2009 Level - II - Mock - Exam - Afternoon PDF

2009 Level II Mock Exam: Afternoon Session
The afternoon session of the 2009 Level II Chartered Financial Analyst® Mock Examination has
60 questions. To best simulate the exam day experience, candidates are advised to allocate an
average of 18 minutes per item set (vignette and 6 multiple choice questions) for a total of 180
minutes (3 hours) for this session of the exam.
Questions Topic Minutes
1-6 Ethical and Professional Standards 18
7-12 Alternative Investments 18
13-18 Financial Statement Analysis 18
19-24 Financial Statement Analysis 18
25-30 Corporate Finance 18
31-36 Equity Investments 18
37-42 Equity Investments 18
43-48 Fixed Income Investments 18
49-54 Derivative Investments 18
55-60 Portfolio Management 18
Total: 180
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Questions 1 through 6 relate to Ethical and Professional Standards.
SMC Case Scenario
Ian Sherman, CFA, is a portfolio manager at SMC, an investment advisory firm which offers
investment products and services to individual and institutional clients. SMC has adopted the
CFA Institute Research Objectivity Standards and implemented policies in compliance with the
Standards.
All of SMC’s investment professionals have earned CFA charters. Sherman tells prospective
clients, “The CFA charter is the highest credential in the global investment management
industry. As charterholders we are committed to the highest ethical standards. Completion of
the program has dramatically improved the team’s portfolio management knowledge and their
ability to achieve better performance results.”
Sherman has earned a reputation for consistently outperforming the market. Over the long run,
his mutual funds have outperformed their respective market benchmarks by a wide margin. For
the past 12 months the funds have slightly underperformed the benchmarks. Some clients have
noticed that Sherman’s fund performance information has not been updated on the advisor’s
website in the past six months. When clients inquire about fund performance, Sherman provides
them with accurate updated information.
Annette Martineau, CFA, works as an analyst for Sherman and presents her recently completed
research report and sell recommendation on Muryan Corporation, which is held in one of
Sherman’s funds to SMC’s Investment Committee. After much debate about the company and
its prospects, the committee reaches a consensus recommendation that is contrary to Martineau’s.
Martineau informs Sherman, “I accept that the committee’s recommendation has a reasonable
basis, but I strongly believe that my recommendation is more appropriate. I have been diligent in
my research and have a deeper understanding of the industry and its competitive factors.”
The following week, Martineau prepares for an investment conference, open to the general
public but typically attended only by investment professionals, by reviewing SMC’s policies
regarding public appearances. The policies state:
1) Employees should remind audience members to judge the suitability of the investment in
light of their own unique circumstances.
2) Employees should make full disclosure of all conflicts of interest, both their own and
those of the firm.
3) Employees may not provide research reports to audience members. Research reports are
reserved exclusively for SMC clients.
During the conference, private equity firm Caruso Limited announces a takeover bid for Muryan.
Immediately, Muryan shares increase 30 percent in value. Martineau is skeptical of the
transaction as she doubts that the Caruso partners fully understand the changing industry
dynamics of the target firm. She hypothesizes that they would cancel the deal if they did.
Concerned that Caruso will eventually cancel the deal, Martineau drafts an updated report and
reiterates her sell recommendation on Muryan. Since SMCs Investment Committee had
overturned her previous sell recommendation on Muryan she goes into great detail as to why she
believes Caruso will not complete the deal. She emails the recommendation to Sherman the next
afternoon.
That evening, Martineau considers what action to take regarding the 5,000 shares of Muryan held
in her husband’s personal account. The firm’s policy on personal investments and trading
requires that Martineau receive approval from the compliance department in advance of all
trades in securities in subject companies in her assigned industry. She is concerned that if
Sherman accepts her recommendation to liquidate all fund holdings of Muryan, the stock price
will drop before she receives approval from the compliance department. Martineau decides to
use derivatives to hedge her husband’s position because these types of trades do not require
advance approval from the compliance department.
The next morning, on Martineau’s recommendation, Sherman’s trader sells all of SMC’s mutual
fund’s entire positions of Muryan for a sizable gain. Martineau hedges her husband’s position.
Several weeks later, as Martineau had hypothesized, Caruso cancels the deal and Muryan’s stock
price declines 20 percent. Martineau’s derivatives position effectively hedges her husband’s
position in the stock.
Sherman learns that a wealthy investor in the fund might liquidate his holdings due to doubts
about suitability and economic forecasts. Sherman carefully reviews the client’s investment
objectives, and informs the client, “You should not sell. Our fund is still suitable for you. You
have been invested with us throughout the past 12 years and I urge you to continue to stay fully
invested. I was just looking at the investment record of a former client who happens to be a
relative of mine, Karoll Reeves, who has traded in and out of our funds during that same period.
Her returns have badly lagged yours.” The client elects to maintain his holdings in Sherman’s
fund.
A month later, Martineau leaves SMC and starts the Galaxy hedge fund with Anjali Shah as her
partner. The first client to commit to the hedge fund instructs the Galaxy partners to direct its
trades through RLB Securities. RLB charges higher-than-average fees, but provides some
unique informational services to investors. In return for receiving Galaxy’s trading business,
RLB promises to refer potential clients to Galaxy. Shah tells Martineau “A larger client base
will create economies of scale and will eventually allow Galaxy to lower its expenses for all
clients.” Martineau agrees. She and Shah explain the directed brokerage arrangement carefully
to prospective clients. They require each client to sign a statement that reads, “It is not necessary
for Galaxy to seek best price and execution, and I am aware of the consequence for my account.
I consent to Galaxy’s trades being executed by RLB Securities.”
1. In which of the following actions does Sherman most likely comply with the requirements
and recommendations of the CFA Institute Standards of Professional Conduct? When he:
A. references the CFA program and designation.

B. provides performance information on the advisor’s website.
C. references the enhanced portfolio management skills of his team.
2. According to CFA Institute Standards, Martineau’s best immediate course of action

regarding her initial research report and recommendation on Muryan is to:
A. leave her name on the report and take no further action.

B. leave her name on the report and document her difference of opinion.
C. issue her own independent recommendation since she has a reasonable basis.
3. Which of SMC’s policies regarding public appearances is least likely consistent with both
the requirements and recommendations of the CFA Institute Research Objectivity
Standards?
A. Statement 1.
B. Statement 2.
C. Statement 3.
4. Martineau’s actions regarding her husband’s account most likely violate the CFA Institute
Research Objectivity Standards because she:
A. did not receive advance approval from the compliance department for trades in her
assigned industry.
B. trades within the restricted trading period of at least 5 calendar days prior to and after
issuing a research report.
C. should seek to ensure that trades for immediate family members are not done in
advance of or disadvantage investing clients.
5. Concerning the client who wants to liquidate his holdings, which of the following CFA
Institute Standards is most likely violated by Sherman?
A. Confidentiality.
B. Conflict of interest.
C. Communication with client.
6. Which of the following actions correctly states why Martineau’s relationship with RLB
Securities would most likely violate CFA Institute Standards?
A. Galaxy is prohibited from referring brokers to any client.

B. Galaxy fails to explain the consequences of average quality execution.
C. Galaxy should trade client accounts through RLB only if the accounts receive best
price and execution.
Questions 7 through 12 relate to Alternative Investments.
Lundberg Case Scenario
John Lundberg, CFA, is a fixed income manager who is talking to a potential client, Brandy
Wing, about asset backed bonds.
Wing: I am new to asset backed securities (ABS) and given all of the problems lately with these
securities I am trying to figure out who the players are. Excluding third parties, who is primarily
involved in the securitization?
Lundberg: The three main parties to the transaction are the seller or originator, the servicer, and
the insurer.
Wing: Can you explain the different characteristics of amortizing and non-amortizing assets in
securitizations?
Lundberg: Amortizing assets require periodic payments of principal and interest, while non-
amortizing assets’ periodic payments consist solely of the interest due. Collateral for secured
amortizing assets does not change in composition, but the composition of collateral for secured
non-amortizing assets does change. All principal repayments from the collateral are distributed
as received to the security holders for amortizing assets, but only after the lockout period for
non-amortizing assets.
Wing: Can you explain credit tranching?
Lundberg: The benefit of credit tranching is that defaults are absorbed by the subordinate
tranche, but any subsequent prepayments are distributed to that tranche in order to recover the
loss.
Wing: For many years I have invested in muni bonds and would like a bond with credit
enhancement.
Lundberg: With an ABS, you have three forms of protection available. Insurance provides for
payment of interest and principal of a specified percentage of the par value at origination should
the issuer fail to make the payments. With overcollateralization, the value of the collateral
exceeds the amount of the par value of the outstanding securities issued at par. Excess spread
reserves are created when cash inflows exceed payments to investors and other parties and are
set aside to pay for potential future losses.
Wing: Can you tell me why collateralized debt obligations (CDOs) are issued?
Lundberg: CDOs are categorized based upon the motivation of the sponsor. In a balance sheet
motivated transaction, the sponsor seeks to remove debt instruments from its balance sheet.
The motivation in an arbitrage transaction is for the sponsor to earn the spread between the yield
offered on the debt obligations in the underlying pool and the payments made to the various
tranches in the structure.
Wing: Can you explain differences between cash and synthetic CDOs?
Lundberg: Cash CDO investors have legal ownership of the underlying pool of assets. Synthetic
CDO investors have only economic exposure to the underlying assets. Unlike cash CDOs,
synthetic CDO structures do not have subordinate/equity tranches.
7. Lundberg’s statement about the parties in a securitization is incorrect with respect to:
A. Insurers
B. Servicers
C. Originators
8. Which one of Lundberg’s comments about amortizing and non-amortizing assets is

correct?
A. Periodic payments
B. Principal repayments
C. Collateral composition
9. Is Lundberg’s explanation of credit tranching correct?
A. Yes
B. Only with respect to the treatment of defaults.
C. Only with respect to the treatment of prepayments.
10. Which of Lundberg’s comments about the types of credit enhancements is incorrect?
A. Insurance
B. Excess spread
C. Overcollaterization
11. Are Lundberg’s comments about the motivations for creating CDOs correct?
A. Yes
B. No, only the comment concerning arbitrage transactions.
C. No, only the comment concerning balance sheet transactions.
12. Which of Lundberg’s comments about differences between cash and synthetic CDOs is
incorrect?
A. Subordinate/equity tranches
B. Legal ownership of underlying assets
C. Economic exposure to underlying asset
Questions 13 through 18 relate to Financial Statement Analysis
Bobby Lee Case Scenario
Bobby Lee, CFA, is an equity analyst for the U.S. investment management firm
Dumas Freres. Dumas Freres holds a substantial position in Skylark Industries, a
U.S.-based company. In reviewing the position, Lee decides to look at how
employee benefits and stock option compensation have affected the financial
statements. In 2006, Skylark adopted SFAS No. 158 the 2006 standard on
pension accounting.
First he collects information regarding Skylark’s pension plan (Exhibit 1) and

pension plan assumptions (Exhibit 2). Lee specifically wants to consider whether
Skylark is using certain assumptions to minimize its:
1. Projected Benefit Obligation (PBO) at year-end 2008, or,

2. pension related compensation expense for 2008.
Exhibit 1
Selected Skylark Pension Plan Data
as of 31 December (U.S.$ millions)
Funded Status of the Plan 2008 2007
Benefit obligation at end of the year (PBO) 972 902
Fair value of plan assets at beginning of the year 514 430

Actual return on plan assets 56 54
Employer/Employee contributions 78 72
Benefits paid -44 -42
Other changes to plan assets
Fair value of plan assets at end of the year 604 514
Funded status -368 -388

Unrecognized net loss 200 224
Unrecognized prior service cost 7 10
Components of net periodic benefit cost

Service cost 60 45
Interest cost 54 47
Expected return on plan assets -51 -43
Other amounts recognized 27 13
Net periodic benefit cost $90 $62
Exhibit 2
Selected Skylark Pension Plan Assumptions
Pension plan assumptions and other
information 2008 2007
Expected return on assets 10.0% 10.0%
Discount rate for obligations 6.0% 5.5%
Expected rate of compensation increases 3.0% 2.5%
Actual return on assets 10.9% 12.6%
Vesting Period 4 years 3 years
Next Lee collects the following information about Skylark’s executive stock option
compensation plan:
1. On 1 January each year, Skylark grants senior executives 1,200,000 options with a
vesting period of four years.
2. The exercise price of the options is set at 140 percent of the closing stock price on the
grant date.
Lee is considering whether Skylark is using certain assumptions (Exhibits 3 and 4) to minimize
its stock compensation expense in 2008.
Exhibit 3
Selected Skylark Stock Option Data
2008
Fair value of options at grant
date, 1 January 2008 $3.25
Exercise price of options 140% of closing stock price on grant date
# of options granted 1,200,000
Vesting period 4 years
Time to expiry 10 years
Basis of option valuation Black-Scholes model
Exhibit 4
Selected Share Price Information and Option Valuation Assumptions
as at 1 January,
2008 2007
Share Price $11.15 $10.00
Dividend yield 1.85% 1.25%
Volatility 34% 32%
Risk-free rate 5% 4%
13. With regard to his concern about the PBO assumptions at the end of 2008
(Exhibit 2), Lee should focus on the disclosures related to the:
A. discount rate.
B. expected return on plan assets.
C. expected rate of compensation increases.
14. Under SFAS No.158, the pension liability recognized on the balance sheet
($ millions) at 31 December 2008 is closest to:
A. 161.
B. 368.
C. 972.
15. Which of the following would best support Lee’s concern about the pension
related compensation expense in 2008? The change in the:
A. discount rate.
B. vesting period.
C. actual return on assets.
16. The 2008 economic pension expense ($ millions) is closest to:
A. 58.
B. 63.
C. 85.
17. The 2008 compensation expense ($ millions) related to the stock options
issued in 2008 is closest to:
A. 0.390
B. 0.975.
C. 1.338.
18. Which of the following would best support Lee’s concern about the stock
related compensation expense in 2008?
A. The risk-free rate.

B. The dividend yield.
C. The share price volatility
Questions 19 through 24 relate to Financial Statement Analysis
Ebba Nyberg Case Scenario
Ebba Nyberg is a fixed income analyst with a Swedish investment firm. Nyberg is analyzing the
financial statements of Sweet Home A/B, a Swedish home furniture manufacturer and retailer.
Sweet Home is listed on both the Stockholm and New York stock exchanges and prepares its
financial statements in accordance with U.S. Generally Accepted Accounting Principles (U.S.
GAAP).
Nyberg’s supervisor, Ander Gustafson, asks Nyberg to continue his preliminary evaluation of
Sweet Home’s creditworthiness and quality of earnings. He asks her to examine Sweet Home’s
liquidity by calculating its free cash flow to the firm and the quality of earnings by using the
cash-flow-statement-based accrual ratios. His initial analysis is contained in Exhibit 1. Nyberg
uses the unadjusted financial statements in her initial calculations.
Sweet Home’s financial statements are summarized in Exhibits 2 to 4.

Nyberg also uses information from the management discussion and analysis (MD&A) section of
Sweet Home’s 2007/8 annual report to adjust Sweet Home’s reported debt, modify its working
capital and assess its quality of earnings. The MD&A states:
1. “During 2007/8 Sweet Home guaranteed bank loans of non-consolidated

subsidiaries, sold receivables with partial recourse, and took advance payments
from large customers when possible.”
2. “Despite overall worsening economic conditions the allowance for doubtful
accounts was significantly reduced by SEK 150 million.”
3. “Sweet Home uses the last-in, first-out (LIFO) method for inventories resulting in
a reserve of SEK 83 million compared to a first-in, first-out (FIFO) valuation.”
4. “Sweet Home uses declining balance depreciation for all fixed assets except for
leasehold improvements which are amortized straight-line over the lease term.”
Exhibit 1
Gustafson’s Preliminary Accrual Analysis of
Sweet Home A/B’s Financial Statements
For the Fiscal Years ended 31 March in SEK millions
2007/8 2006/7
Net Operating Assets 8,136 7,213
Cash flow statement
based accruals ratio ? 0.18
Exhibit 2
Condensed Balance Sheet of Sweet Home A/B
Assets 2007/8 2006/7
Cash and cash equivalents 71 31
Trade accounts receivable (net of allowances) 948 590
Inventories 4,238 3,821
Property, plant, and equipment
5,493 4,534
(net of accumulated depreciation)
Total assets 10,750 8,976
Liabilities and Shareholders’ Equity

Trade accounts payable 2,543 1,732
Convertible bond 4,000 4,000
Shareholders' equity 4,207 3,244
Total liabilities and shareholders' equity 10,750 8,976
Exhibit 3
Condensed Income Statement of Sweet Home A/B
2007/8 2006/7
Net sales 26,832 23,201
Cost of goods sold (COGS) (19,228) (16,556)
Selling, general & administrative expenses (5,462) (4,796)
(SG&A)
Interest expense (net of interest income) (290) (295)
Income taxes @35% (648) (544)
Net income 1,204 1,010
Exhibit 4
Condensed Cash Flow Statement of Sweet Home A/B
2007/8 2006/7
Net income 1,204 1,010
Depreciation and amortization 293 252
(Increase) decrease in working capital 36 (123)
Cash flow from operating activities (CFO) 1,533 1,139
Additions to property, plant, and equipment (1,317) (1,372)

Disposition of property and equipment 65 50
Cash flow from investing activities (CFI) (1,252) (1,322)
Cash dividends (241) -

Cash flow from financing activities (CFF) (241) -
Net increase (decrease) in cash and cash equivalents 40 (183)
19. Sweet Home’s 2007/8 free cash flow to the firm (in SEK millions) is closest to:
A. 368.5.
B. 404.5.
C. 506.0.
20. After completing the analysis Gustafson had started in Exhibit 1, the most appropriate
conclusion that Nyberg can make about earnings quality is that it has:
A. improved because it is lower than 0.18.

B. improved because it is higher than 0.18.
C. deteriorated because it is higher than 0.18.
21. Which factor stated in the first quote of the MD&A will Nyberg least likely use to adjust
Sweet Home’s reported debt?
A. Guarantees.
B. Sale of receivables.
C. Advances from customers.
22. Compared to its reported 2007/8 financials, after Nyberg adjusts Sweet Home’s working
capital given the second and third quote of the MD&A, the most likely effect will be that:
A. both accounts receivable and inventories will be lower.

B. accounts receivable will be lower and inventories will be higher.
C. accounts receivable will be higher and inventories will be lower.
23. Compared to its reported 2007/8 financials, if Nyberg adjusts Sweet Home’s financial
statements given the second quote of the MD&A, the effect (in SEK millions) on total
assets and net income will most likely be a:
A. 150 decrease in both total assets and net income.

B. 97.5 decrease in total assets and no effect on net income.
C. 150 decrease in total assets and a 97.5 decrease in net income.
24. Which of the following activities of Sweet Home A/B would least likely indicate a lower
quality of earnings for the company to Nyberg? The company’s:
A. sale of receivables with partial recourse.

B. choice of depreciation methods for fixed assets.
C. guarantee of bank loans for non-consolidated subsidiaries.
Questions 25 through 30 relate to Corporate Finance
Felipe da Rocha Case Scenario
Felipe da Rocha, CFA, heads the capital budgeting committee for Brasilia Distribuidora, SA
(BD), a privately held Brazilian electronic components wholesaler. The committee has two
mutually exclusive proposals to evaluate. One proposal is from BD’s Northern Division, which
requests BRL 30 million (Brazilian real) to construct a new distribution center. Specific details
of this proposal are presented in Exhibit 1. The second proposal is from BD’s Southern
Division, which requests BRL 25 million to form a joint venture with a producer of electrical
components. Details of this proposal are presented in Exhibit 2.
Exhibit 1
Selected Data for Distribution Center Proposal
(currency amounts in BRL thousands)
Initial fixed capital outlay (5,000 allocated to land) 30,000
Increase in net working capital 20,000
Annual sales revenues (cash) 50,000
Annual operating costs (cash) 30,000
Annual depreciation 1,000
Investment horizon Six years
Salvage value (book) at end of investment horizon 24,000
Salvage value (market) at end of investment horizon 22,000
Marginal tax rate 40%
increase in net working capital accounts will be recovered at end of
investment horizon.
4 percent straight-line depreciation on buildings of BRL 25 million.
Exhibit 2
Selected Data for Joint Venture Proposal
Initial fixed capital outlay 25,000
Increase in net working capital 15,000
Annual sales revenues (cash) 65,000
Annual operating costs (cash) 40,000
Annual depreciation 2,000
Investment horizon Three years
Salvage value (book) at end of investment horizon 19,000
Salvage value (market) at end of investment horizon 26,000
in net working capital accounts will be recovered at end of investment horizon.
straight-line depreciation of initial fixed capital outlay.
In the case of the distribution center, the entire project will be sold in six years when a new
highway opens between BD’s primary customers in the north. The initial term of the joint
venture is three years. BD can extend the joint venture for three more years by replicating the
project as shown in Exhibit 2 (e.g., identical capital outlay as well as cash inflows, outflows, and
salvage value). At the end of the joint venture, BD will transfer its interests to the joint venture
partner. At least initially, both projects will be analyzed using a 10 percent discount rate.
Selected data for Brasilia Distribuidora are shown in Exhibit 3.
Exhibit 3
Selected Data for Brasilia Distribuidora, SA
Book value of long-term debt 1,400,000
Market value of long-term debt 1,370,000
Book value of equity 800,000
Market value of equity 1,710,000
Coupon rate on long-term debt 8.00%
Yield-to-maturity on long-term debt 8.50%
Asset 1.0
Estimated debt beta 0.0
Expected return on market 9.50%
Expected market risk 5.00%
Marginal tax rate 40%
pure-play (unlevered) beta derived from a publicly traded firm.
Index, São Paolo.
for Bovespa Index, São Paolo.
Prior to selecting between the two proposals, the capital budgeting committee asks da Rocha to
address the following questions:
1. Assuming that the net present value (NPV) of the distribution center is
approximately BRL 30 million and using a discount rate of 10 percent, can the
joint venture proposal be analyzed using the equivalent annual annuity method?
2. Because a contract for electrical components remains under negotiation, the joint
venture partner wants to evaluate the project with annual operating costs that are
20 percent higher than originally forecast. How will this impact the project’s
NPV, assuming a discount rate of 10 percent and a term of three years, while
holding all else constant?
3. If the joint venture project’s levered beta were 1.2, instead of equal to that of
BD’s typical project, what would be the appropriate required rate of return on
equity?
4. What may we conclude about the use of NPV or internal rate of return (IRR)
methods as a selection criterion for mutually exclusive projects?
25. The total after-tax cash flow (in BRL thousands) to be derived from the proposed
distribution center in its terminal year is closest to:
A. 35,200.
B. 53,600.
C. 55,200.
26. Using the assumptions from question 1 asked of da Rocha, the equivalent annual annuity
(in BRL millions) for the distribution center project would be closest to:
A. 3.89.
B. 5.00.
C. 6.89.
27. da Rocha’s most accurate response to question 2 is that NPV (in BRL thousands) will
most likely be reduced by:
A. 7,958.
B. 11,937.
C. 19,895.
28. da Rocha’s most accurate response to question 3 is that the required rate of return on
equity for the joint venture project would be closest to:
A. 9.50%.
B. 10.50%.
C. 15.90%
29. da Rocha’s most accurate response to question 4 is that:
A. projects with longer lives will offer higher IRRs.

B. IRR and NPV methods can differ in their selection of such projects.
C. for projects with non-conventional cash flows, IRR is more economically meaningful
than NPV.
30. If the proposed distribution center were financed 40 percent by debt, the accounting
income (in BRL thousands) for the first year would be closest to:
A. 10,125.
B. 10,635.
C. 10,680.
Questions 31 through 36 relate to Equity Investments
Skate-O-Rama Case Scenario
Charville Securities International/Canada

Roxanne Bouvier, CFA Recreation
6 March 2009
Skate-O-Rama, Inc. (SKATE)

Price: $36.00 CAD 12-Month Price Objective: $45.00 CAD
Skating on Thin Ice? BUY
Company Description
Skate-O-Rama is Canada’s largest owner and operator of recreational ice facilities and the only
one that is publicly traded. In addition to ice rinks, their facilities all contain sports bars and
restaurants that overlook the ice, and retail stores that sell equipment and clothing. The company
generates revenue from three sources: in-house skating programs (71 percent of revenues), food
and beverage operations (20 percent), and retail stores (9 percent). The company’s in-house
programs focus on skating lessons, youth and adult hockey leagues, multi-sport day camps, and
sports tournaments.
Visit with Skate-O-Rama management reinforces our Buy rating
After participating in a publicly held conference call, we are reiterating our Buy recommendation
and consider SKATE our top equity selection for 2009. The company’s pursuit of both cost
leadership and differentiation strategies has enabled it to charge premium prices for its in-house
skating programs, while at the same time lowering operating costs through economies of scale.
Based on our analysis of industry structure, the competitive forces influencing the industry are:
low barriers to entry, intense rivalry among competitors, weak bargaining power of buyers
(customers), and strong bargaining power of suppliers. However, a key factor contributing to
SKATE’s profitability is management’s continued ability to capture the value that they create for
customers. Therefore, we have a high degree of confidence in both our revenue projections and
our above-consensus EPS estimates for 2010 and 2011 (Exhibits 1 and 2).
Three important conclusions after the conference call:
• In 2009 enrollments in in-house hockey programs and figure and speed skating
classes are increasing.
• Management’s development and delivery of high quality programming has had a
beneficial impact on food and beverage revenues and retail sales.
• Management plans to continue to expand geographically, by acquiring
individually owned ice rinks and converting them into recreational ice sports
arenas by redesigning the facilities (adding restaurants, bars, and retail stores) and
developing skating programs.
We view SKATE as undervalued with strong future growth potential
We believe our estimate of a three year cumulative annual growth rate (CAGR) in EPS provided
in Exhibit 1 is conservative due to our expectations of: a) 10 percent growth in program
enrollment; b) 12 percent growth in food and beverage revenues; c) an 8-10 percent increase in
retail sales per square foot; and d) 40-60 basis points of annual operating margin improvement
that reflects economies of scale and improved product pricing.
We believe that SKATE will continue to generate a positive franchise value that will accrue to
the existing stockholders. Using a franchise value approach and computing an intrinsic price-
earnings ratio, we believe that SKATE’s current stock price does not fully reflect the present
value of the company’s future investment opportunities and the return levels associated with
these opportunities. Therefore, we expect SKATE’s price-earnings multiple to expand further as
the market revalues the company in the context of its greater size, earnings power, and ability to
create shareholder value.
Price Objective & Risk
We are reiterating our Buy recommendation on SKATE with a 12-month price objective of $45.
This assumes that SKATE trades at 16.0X our 2010 estimated EPS of $2.25 and 17.3X our 2011
estimated EPS of $2.60. Risks to our price objective include: a slowdown in consumer spending
and a decline in disposable income.
If the above two risk factors become severe, the company may experience no real growth in
earnings. In that event, as SKATE can pass along only 60 percent of inflation effects to its
customers, our P/E estimates and 12-month price objective for the stock might not be realized.
Exhibit 1
Estimates and Assumptions
Recreation
Skate-O-Rama
Industry Average
Estimated 2010 ROE 18.0% 20.0%
Estimated 2011 P/E 16.0X 14.0X
Expected EPS Growth Rate 15.0% 12.0%
Dividend Payout Ratio 20.0% 15.0%
Nominal Required Rate of Return 15.0% ---
Expected Inflation 5.0% 5.0%
Exhibit 2
Selected Financial Data For the Year Ending 31 December 2008
(In CAD$ millions)
Recreation
Skate-O-Rama
Industry Average
Revenue 46.00 54.00
Earnings before interest and taxes 6.00 9.00
Earnings before taxes 4.75 5.75
Net Income 2.88 3.00
Total assets (average) 123.00 145.00
Total equity (average) 16.00 15.00
31. Based on Bouvier’s analysis of the industry structure, SKATE’s ability to capture value is
most likely due to:
A. barriers to entry.
B. bargaining power of buyers.
C. bargaining power of suppliers.
32. Based on Exhibit 2 and the DuPont Model, Skate-O-Rama’s lower 2008 return on equity
compared to the recreation industry is best explained by:
A. net profit margin.

B. financial leverage.
C. operating leverage.
33. Based on Exhibit 2 and the DuPont Model, Skate-O-Rama’s higher 2008 net profit
margin compared to the recreation industry is best explained by:
A. pretax margin.
B. interest burden.
C. operating margin.
34. Using Bouvier’s assumptions in Exhibit 1, Skate-O-Rama’s franchise P/E as of 31

December 2008 is closest to:
A. 16.67.
B. 17.79.
C. 26.67.
35. Using Bouvier’s assumptions in Exhibit 1 and the franchise value approach, Skate-O-
Rama’s intrinsic P/E as of 31 December 2008 is closest to:
A. 20.0.
B. 33.3.
C. 42.7.
36. Considering the two risk factors and the inflation related effects, the most accurate
estimate of SKATE’s intrinsic P/E ratio using prospective earnings is:
A. 7.69.
B. 8.33.
C. 12.50.
Questions 37 through 42 relate to Equity Investments
Carl Heuser Case Scenario
Carl Heuser is senior equity analyst with Kaleidoscope AG, a specialized Austrian research
company. Heuser has recently assumed responsibility for the global food and beverage industry
and is preparing an industry study. A colleague, Joseph Mayer, who is working on parts of the
report, asks why Heuser places so much emphasis on valuation, given that in efficient markets
prices correctly reflect fair market values. Heuser states that valuation models help:
• determine objective prices.

• estimate intrinsic stock values.
• assess the impact of corporate events.
• infer market expectations reflected in prices.
Mayer also questions the use of relative valuation models. He argues that absolute valuation
models help determine an asset’s intrinsic value, whereas relative valuation models specify an
asset’s value relative to another asset or a benchmark value.
Heuser is focusing his analysis on chilled foods, because he classifies this sub-industry to be in
the growth phase of its life cycle. He investigates French Belle Cuisine S.A. and American Fast
Foods, Inc. Belle Cuisine makes branded products served in private hospitals. In this niche
market, Belle Cuisine strives to remain the quality leader at reasonable production costs. In
contrast, American Fast Foods is a mass-market producer. Its success is based on reasonable
quality with highly cost-efficient production. Heuser gathers financial information, shown in
Exhibit 1, about both companies.
Exhibit 1
Belle Cuisine S.A. and American Fast Foods, Inc.
Selected Financial Information, Year End
(in millions, Euros)
Belle Cuisine, American
S.A. Fast Foods, Inc.
Sales 120.0 200.0
Earnings before interest and taxes 17.0 30.0
Earnings before taxes 9.0 14.0
Net income 6.0 9.3
Assets 200.0 225.0
Equity 40.0 50.0
Dividend payout ratio 40.0% 40.0%
Required rate of return on the stock 16.0% 16.0%
Analyzing the competitive forces within the chilled foods sub-industry, Heuser finds that Belle
Cuisine, American Fast Foods, and their various competitors buy ingredients from a large
number of suppliers. Although both companies currently experience above industry average
operating returns, Heuser notes that Belle Cuisine depends on five private hospital groups for
more than 75 percent of its sales. American Fast Foods, on the other hand, sells to a broad range
of customers throughout the country.
In his study Heuser rates the chilled foods sub-industry to be attractive for investors because,
considering the industry structure, companies can capture a high proportion of the product value
created. He states that the:
• industry growth is an element in determining rivalry.

• absence of supplier concentration keeps input factor costs low.
• buyer propensity to substitute reduces intensity of rivalry.
Finally, Heuser makes the following two concluding statements:

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

• product acceptance is established.
• shifting consumer tastes drive the sub-industry.
37. Mayer’s arguments concerning absolute and relative valuation models are most accurate
with respect to:
A. both types of models.

B. relative valuation models only.
C. absolute valuation models only.
38. Based on DuPont analysis, American Fast Foods’ higher return on equity, compared to
that of Belle Cuisine, is due most likely to American’s:
A. lower tax burden.

B. higher asset turnover.
C. higher net profit margin.
39. Which of the following best describes Belle Cuisine’s bargaining power of buyers and
suppliers? The bargaining power of:
A. both buyers and suppliers is low.

B. buyers is high but that of its suppliers is low.
C. suppliers is high but that of its buyers is low.
40. With regard to capturing product value created as a result of industry structure, Heuser’s
least accurate statement relates to:
A. industry growth.
B. supplier concentration.
C. buyer propensity to substitute.
41. In regard to Heuser’s two concluding statements, it is most accurate to say that he is:
A. correct with respect to both statements.

B. incorrect with respect to both statements.
C. correct with respect to statement (2) but not statement (1).
42. In the context of the industry life cycle, Mayer’s classification of the chilled food sub-
industry is best supported by his argument relating to:
A. business failures.
B. product acceptance.
C. shifting tastes driving the sub-industry.
Questions 43 through 48 relate to Fixed Income Investments.
Mike Sutherland Case Scenario
Mike Sutherland is a mortgage-backed securities (MBS) analyst for a University endowment

investment group and is evaluating the possible purchase of a MBS in the endowment’s fixed
income portfolio. He is considering several U.S. government agency collateralized mortgage
obligation (CMO) tranches. Because he is concerned interest rates will increase over the next 12
months, he wants to invest in a MBS-CMO rather than a pass-through MBS (MBS-PT).
Sutherland’s additional investment objective is to purchase an MBS-CMO with principal

repayments that approximate the principal repayment of a ‘bullet’ corporate bond. Selected
characteristics for several MBS-CMO tranches are found in Exhibit 1. The current principal
prepayment rate is 275 PSA.
Exhibit 1
Selected Tranche Information for CMO FNR 2005-XX
Effective PAC Expected Principal
MBS-CMO Tranche Collar (PSA) Repayment Dates
PAC1 (PAC Bond) 125-400 Feb. 2009 to March 2010
PAC2 (PAC Bond) 125-325 March 2010 to May 2011
PAC3 (PAC Bond) 135-285 May 2011 to June 2012
PAC4 (PAC Bond) 135-295 June 2012 to June 2014
SUP (Support Bond) n/a June 2007 to Dec. 2007
FLT* (Support Bond) n/a June 2007 to March 2035
* FLT is a floating-rate tranche with its coupon equal to 3 month LIBOR + 45 bps
One of Sutherland’s colleagues asks if he considered purchasing an interest only (IO) stripped
MBS-PT because its value should increase as interest rates rise. Sutherland replies that although
the IO’s value should increase as interest rates rise above the contract rate, it is not an option
because he can only purchase securities with principal repayments.
As Sutherland continues his analysis, he decides to evaluate the MBS-CMO PAC Bond tranches
on an option adjusted spread (OAS) basis. Sutherland wants to examine how changing interest
rate volatility might affect the OAS and price for each MBS-CMO tranche. He summarizes his
analysis in Exhibit 2.
Exhibit 2
OAS Analysis
Interest Rate Volatility of 10% and 30%
Change in Price per $100 par
Current Current OAS New OAS (holding OAS constant)
MBS-CMO Tranches Z-Spread 20% Vol 10% Vol 30% Vol 10% Vol 30% Vol
PAC1 76 36 56 13 0.39 -0.76
PAC2 92 54 79 5 1.12 -1.70
PAC3 98 63 93 13 1.87 -1.36
PAC4 113 67 89 (2) 1.60 -3.63
Sutherland assumes a binomial interest rate tree model was used to calculate the OAS for the
MBS-CMO PAC Bonds shown in Exhibit 2 because prepayment risk is just another form of call
option risk.
Sutherland then turns his attention to measures of duration for MBS-CMOs. He knows that
MBS-CMO duration can be calculated by using Monte Carlo simulation, but that cash flow
duration is an alternative measure. He believes that the cash flow duration measure is more
reliable than Monte Carlo simulation because the former uses static principal prepayment
assumptions to determine the bond values used to calculate the effective duration.
43. Given Sutherland’s concern regarding interest rates, the risk he is most likely attempting
to avoid is:
A. liquidity risk.
B. extension risk.
C. contraction risk.
44. Based on Exhibit 1, the MBS-CMO tranche that will most likely satisfy Sutherland’s
investment objectives is:
A. SUP.
B. PAC1.
C. PAC3.
45. Are Sutherland’ statements regarding an IO’s value and principal repayment,
respectively, most likely correct?
A. Yes.
B. No, he is incorrect regarding an IO’s value.
C. No, he is incorrect regarding principal repayment.
46. Based on Exhibit 2, the MBS-CMO tranche with the most attractive relative OAS and
price sensitivity most likely is:
A. PAC1.
B. PAC3.
C. PAC4.
47. Is Sutherland most likely correct in using a binomial interest rate model?
A. Yes.
B. No, because CMO OAS is a function only of the level of interest rates.
C. No because CMO OAS is a function of the level of interest rates and the evolution of
interest rates over time.
48. Is Sutherland’s belief about the reliability of the cash flow duration measure most likely
correct?
A. Yes.
B. No, because cash flow duration can only be used when cash flows are not affected by
changes in interest rates (i.e., non callable bonds).
C. No, because cash flow duration is based on naïve assumptions of how prepayment
rates change over the life of an MBS for given interest rate changes.
Questions 49 through 54 relate to Derivative Investments.
Tarja Stahlberg Case Scenario
Tarja Stahlberg, the company treasurer for the Finnish-based Borealis Group Oyj, is planning to
repatriate ₤100 million from its British subsidiary. She intends to convert the British pounds to
euros (the home currency for Borealis) in 90 days.
Nicholas Howell is advising Stahlberg on these transactions. Stahlberg has told Howell that she
wants to protect Borealis against the possibility that the British pound depreciates against the
euro before the funds are repatriated.
Howell suggests that Stahlberg consider the use of foreign currency options. In particular, a
European call option on euros will allow Borealis to hedge its foreign currency risk. Howell
makes the following statements:
Statement 1: “The call option price will decrease as the time to expiration decreases or the
exercise price decreases; and is very sensitive to the risk-free rate.
Statement 2: You can use 90-day call options on the euro with a strike price of ₤0.6400. The
current 90-day forward exchange rate is ₤0.6500. A synthetic European call option on the euro
can be created by combining a long put position on the euro, a short position in a forward
contract on the euro, and a short position in a zero-coupon bond.”
Stahlberg mentions that Borealis will have ongoing U.S. dollar borrowing needs, and that she
wants to use the Eurodollar market to meet these. She prefers to use floating rate debt, and is
considering issuing a U.S. dollar denominated floating rate note (FRN). Stahlberg is concerned
that an increase in U.S. yields before the FRN issuance date will increase her future borrowing
costs (measured in U.S. dollars).
Howell explains how swaps and swaptions can be used to address Stahlberg’s concerns, stating:
Statement 3: “Similar to a forward contract, a plain vanilla interest rate swap can fix borrowing
costs. For example, if you issued a US$100 million FRN today that has a 180-day term and
coupon payments that reset every 90 days at the 90-day LIBOR, a plain vanilla interest rate swap
could convert it to a fixed rate obligation.
Statement 4: A newly entered plain vanilla interest rate swap has no current credit risk, but has
potential credit risk that will increase steadily over the life of the swap.
Statement 5: A receiver swaption permits the holder to enter into a pay floating position and is
equivalent to a put option.
Statement 6: Suppose that you planned to issue a US$100 million FRN in 90 days time that has
a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. You would
want a European swaption with a notional principal amount of US$100 million and a 90-day
expiry at the time of FRN issuance. The data for this example is presented in Exhibit 1.
Exhibit 1
U.S. dollar LIBOR and Fixed Rates
LIBOR, Swap, and Swaption
Today In 90 days
Rates are Annualized
90-day U.S. LIBOR 3.50% 4.00%
180-day U.S. LIBOR 3.85% 4.35%
Fixed rate on swaption 3.90% n/a
Fixed rate on swap n/a 4.32%
90-day discount factor 0.9913 0.9901
180-day discount factor 0.9811 0.9787
49. The information in Statement 1 is correct with respect to:
A. exercise price.
B. time to expiration.
C. risk-free interest rate.
50. Statement 2 is incorrect with respect to which position?
A. put option
B. forward contract
C. zero-coupon bond
51. Given the information in Statement 3 and Exhibit 1, the annualized fixed rate on the plain
vanilla interest rate swap would be closest to:
A. 1.76%.
B. 3.84%.
C. 4.32%.
52. Statement 4 can be best characterized as:
A. correct with respect to current credit risk only.

B. correct with respect to potential credit risk only.
C. correct with respect to both current credit risk and potential credit risk.
53. Statement 5 can be best characterized as:
A. incorrect with respect to the pay floating position.

B. incorrect with respect to the put option equivalency.
C. correct with respect to both put option equivalency and pay floating position.
54. Based on Statement 6 and Exhibit 1, the market value of the swaption at expiration would
be closest to:
A. $206,725.
B. $207,764.
C. $208,961.
Questions 55 through 60 relate to Portfolio Management.
Julia Valverde Case Scenario
Julia Valverde, CFA, is a trust officer at Royal National Bank (RNB). She recently met Luis
Sevilla, age 45, owner of agriculture and real estate partnerships. Valverde hopes that Sevilla
will bring his personal investment business to RNB, as well as that of his partnerships and
perhaps also his family’s philanthropic foundation.
Although Sevilla is fairly knowledgeable, he wants Valverde to analyze two stocks (Bici and
Velo) which have been recommended by his broker at Ekimov Investment Partners. Sevilla tells
Valverde that he will consider only those investments which are expected to return 10 percent
pre-tax. Sevilla provides Valverde with the information in Exhibit 1.
Exhibit 1
Bici and Velo Stock Data
Provided by Ekimov Investment Partners
Closing Price ($) Expected Price ($) Beta vs. DJ Dividend
Company
31 Dec 2008 31 Dec 2009 Wilshire 5000 Index Yield (%)
Bici 30.00 31.50 1.0 3
Velo 20.00 25.00 1.5 0
Valverde begins her analysis by reviewing RNB’s 10-year expected annualized returns for
various markets (shown in Exhibit 2).
Exhibit 2
RNB’s Benchmark Return Estimates
RNB’s Annualized
Asset Class Asset Class Benchmark 10-Year Return Estimates
(%)
U.S. Equity Dow Jones Wilshire 5000 10.0
Index
Global Equity MSCI World Index 12.0
U.S. Fixed Income Lehman Aggregate Index 5.0
Cash Equivalents (risk-free 90-day T-bills 2.0
rate)
As Valverde conducts an analysis of Bici and Velo stock returns, Sevilla asks whether the
assumptions of the Capital Asset Pricing Model (CAPM) are accurate. Specifically, Sevilla
asked Valvarde about the assumptions that all:
1. assets can be traded without taxes or transaction costs.

2. assets are marketable in any quantity without affecting price.
3. investors have different views about the risk and return of risky assets.
Sevilla asks whether an Arbitrage Pricing Theory (APT) model can be used instead of a CAPM
model. Valverde responds that the APT model offers a richer context for investors to make
portfolio decisions and makes less restrictive assumptions than the CAPM. Specifically, the APT
model assumes that:
A. returns are described by a factor model,

B. investors can construct portfolios that eliminate asset specific risk,
C. it is possible for investors to arbitrage among well diversified portfolios
Before she provides an answer regarding the two stocks, Valverde asks Sevilla to complete
RNB’s required “know your customer” questionnaire. Using Sevilla’s responses, Valverde
completes the listing of Sevilla’s total assets (Exhibit 3) and his investment profile (Exhibit 4).
Based on Sevilla’s investment profile, Valverde also develops the Investment Policy Statement
(IPS) shown in Exhibit 5.
Exhibit 3
Questionnaire Responses: Sevilla’s Total Assets
Investment Portfolio Market Value ($) Annual Income
(Type/Name of Asset) December 31, 2008 (in U.S. $)
Quality Hi-Tek Stock Fund 500,000 5,000
Quality Value Stock Fund 500,000 25,000
Personal Real Estate 1,500,000 10,000
Agricultural and Real Estate 76,000,000 300,000
Business
TOTAL ALL ASSETS 78,500,000 340,000
Exhibit 4
Investment Profile for Luis Sevilla
Age 45 years
Willingness to take risk Unafraid of loss
Tax concerns Tax rate is usually in the range 30% to 35%
Unique circumstances Plans to gift $100,000 / year to charity from the investment portfolio
Time Horizon Wants to retire at age 55 years. In retirement, wants to live on savings
Exhibit 5
Sevilla’s IPS Developed by Valverde
IPS Element Valverde’s Assessment
Return objective Above average
Risk tolerance Above average
Liquidity needs Not significant
Tax concerns Significant
Unique Circumstances Not significant
Time Horizon Multi-stage
55. Given the U.S. data in Exhibit 1 and Exhibit 2, the expected return for Velo stock (E( ))
using the security market line is closest to:
A. 12.0%.
B. 12.5%.
C. 14.0%.
56. Which of Sevilla’s three statements regarding the assumptions underlying the Capital
Asset Pricing model is least accurate?
A. Statement 1.
B. Statement 2.
C. Statement 3.
57. Which of Valverde’s three statements about the assumptions of the APT model is least
accurate?
A. Statement A.
B. Statement B.
C. Statement C.
58. Is Valverde’s assessment of Sevilla’s liquidity and unique circumstances, from Exhibit 5,
most likely correct?
A. Yes
B. No, the assessment of liquidity needs is incorrect.
C. No, the assessment of unique circumstances is incorrect.
59. In Exhibit 5, is Valverde most likely correct regarding Sevilla’s taxes and time horizon?
A. Yes
B. No, he is incorrect about taxes.
C. No, he is incorrect about time horizon.
60. Based on the information presented in Exhibits 3 and 4, Sevilla’s ability to take risk is
most likely:
A. average.
B. below average.
C. above average.

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2009 Level II Mock Exam: Afternoon Session

Questions Topic Minutes

1-6 Ethical and Professional Standards 18

7-12 Alternative Investments 18

13-18 Financial Statement Analysis 18

19-24 Financial Statement Analysis 18

25-30 Corporate Finance 18

31-36 Equity Investments 18

37-42 Equity Investments 18

43-48 Fixed Income Investments 18

49-54 Derivative Investments 18

55-60 Portfolio Management 18

SMC Case Scenario

A. references the CFA program and designation.

2. According to CFA Institute Standards, Martineau’s best immediate course of action

A. leave her name on the report and take no further action.

A. Galaxy is prohibited from referring brokers to any client.

Lundberg Case Scenario

Wing: Can you explain credit tranching?

8. Which one of Lundberg’s comments about amortizing and non-amortizing assets is

9. Is Lundberg’s explanation of credit tranching correct?

Bobby Lee Case Scenario

First he collects information regarding Skylark’s pension plan (Exhibit 1) and

1. Projected Benefit Obligation (PBO) at year-end 2008, or,

Fair value of plan assets at beginning of the year 514 430

Funded status -368 -388

Components of net periodic benefit cost

16. The 2008 economic pension expense ($ millions) is closest to:

A. The risk-free rate.

Ebba Nyberg Case Scenario

Sweet Home’s financial statements are summarized in Exhibits 2 to 4.

1. “During 2007/8 Sweet Home guaranteed bank loans of non-consolidated

Liabilities and Shareholders’ Equity

Additions to property, plant, and equipment (1,317) (1,372)

Cash dividends (241) -

A. improved because it is lower than 0.18.

A. both accounts receivable and inventories will be lower.

A. 150 decrease in both total assets and net income.

A. sale of receivables with partial recourse.

Felipe da Rocha Case Scenario

29. da Rocha’s most accurate response to question 4 is that:

A. projects with longer lives will offer higher IRRs.

Skate-O-Rama Case Scenario

Charville Securities International/Canada

Skate-O-Rama, Inc. (SKATE)

Visit with Skate-O-Rama management reinforces our Buy rating

We view SKATE as undervalued with strong future growth potential

Price Objective & Risk

A. net profit margin.

34. Using Bouvier’s assumptions in Exhibit 1, Skate-O-Rama’s franchise P/E as of 31

Carl Heuser Case Scenario

• determine objective prices.

• industry growth is an element in determining rivalry.

Finally, Heuser makes the following two concluding statements:

• it is still at risk for many business failures.

A. both types of models.

A. lower tax burden.

A. both buyers and suppliers is low.

A. correct with respect to both statements.

Mike Sutherland Case Scenario

Mike Sutherland is a mortgage-backed securities (MBS) analyst for a University endowment

Sutherland’s additional investment objective is to purchase an MBS-CMO with principal

Tarja Stahlberg Case Scenario