QUESTION 1 ETHICAL AND PROFESSIONAL STANDARDS

1.1 A Both routine and non routine proxies must be considered and voted. Responsibilities for voting proxies relate to both active and passive portfolios including index funds. A fiduciary may conduct a cost benefit analysis and determine that voting may not benefit the client, but the analysis would need to be done, it would be wrong to simply ignore the votes. Standard III A: Loyalty, Prudence and Care.

1.2

B It is acceptable to delegate the voting of Proxies to a specialist consulting firm in the same way that other tasks may be delegated. Procedures should be put in place to monitor and review decisions taken by such a firm. Whilst proxy voting can be delegated, the overall responsibility for voting proxies cannot be delegated away. The portfolio manager still has a fiduciary duty to check that the interests of the plan beneficiaries are safeguarded.

1.3

C Disclosure is required for all client accounts whether active or passive.

1.4

A Client brokerage earned from one portfolio may be used to purchase research to be used for another portfolio. The Code and Standards do not require that brokerage must benefit the client that generated the trade, but disclosure is necessary of the method or policies to be used in addressing any conflict that may arise. Over time, all clients must benefit There is no breach of duty as best execution is being provided (best execution does not have to mean lowest cost, although cost is a factor). Standard III A.

1.5

B For agency trades then so long as the clients benefit over time then it is OK to use one clients brokerage to benefit another client so long as this is disclosed. Whereas with principal trades disclosure is not sufficient must also gain consent.

185

1.6

A Except where the client directs the brokerage, the investment manager must achieve best execution, however are allowed to pay higher brokerage charges if they determine that additional value is added to the plan beneficiaries through research or other services provided. The service and costs of the broker are looked at as a whole so i is true. The Bloomberg terminal is not directly assisting the investment decision making process, therefore it should not be paid for with client brokerage but by the firm itself. So II is false. A manager is obliged to disclose their policy on soft dollars to clients and prospects where there are benefits not accruing to the client so III is false.

186

QUESTION 2 ETHICAL AND PROFESSIONAL STANDARDS

2.1 B Firstly, Isabella is a CFA Charterholder and bound by the CFAI Code and Standards. Regarding the joint buy recommendation, information from a chat room is not considered adequate research and therefore violates standard V. A Diligence and Reasonable Basis. A more subtle issue in this question is where a CFA Charterholder member or candidate knows that information is likely to be inaccurate but continues their association with it. This subtle rule is a breach of complying with knowledge of the law. You can see this illustrated by an example in this section of the Code and Standards. 2.2 A Dan is not in breach of the CFAI Code & Standards. Firstly regarding his selling for tax reasons this is allowed as long as the intent was not to manipulate the market price. Secondly, Dan is not required to vote all proxies if he decides there is no value to be gained from an insignificant proxy, and his proxy procedures have been disclosed to the client. 2.3 A Isabella did not contact each of her Clients in an equal manner as some were telephoned, some were emailed and some had a written communication. However the CFAI Code & Standards does not require equal treatment but fair treatment. In this respect Isabellas communication process could be justified. Perhaps the Client that complained can be added to the telephone list / e-mail list for future communications. Cordelia may intend to sit her Level I exam at the next sitting, but until she has registered for the exam she is not a candidate.

2.4

C This question requires a distinction between transaction based manipulation and information based manipulation. In the case study Jake is manipulating the price via information. Trading securities between funds to affect market prices would be deemed market manipulation. There is no special exemption for this kind of activity.

187

2.5

B The Research Objectivity Standards do not assure accurate research reports and recommendations. The standards however stringent can never assure all research reports will be accurate. To avoid conflicts of interest, holdings of more than 1% of the stock held by the research company 5 days before the research was published should be disclosed It is recommended that reports and recommendations be issued at least quarterly with additional updates when there is a significant announcement or event regarding the subject company.

2.6

188

QUESTION 3 QUANTITATIVE METHODS

3.1 B The coefficient of determination, R squared, is SSR/SST which is the sum of squared regression over the total sum of squares. This means that the independent variables explain 82% of the total variation in the dependent variable. 3.2 A Conditional Heteroskedasticity Variance of the error changes in a systematic manner related to the independent variables. 3.3 C (ln GDPt ln GDPt-1) = bo + b1( ln GDPt-1 ln GDPt-2) + t = 0.0216 + (0.0642 x ln 1.02) = 0.02287 GDP growth = e0.02287 1 = 0.023

3.4

B Durbin Watson cannot be used for autoregressive models.

3.5

C If the model is ARCH (1) then the lagged squared residual would explain the current squared residual, hence the coefficient would be significantly different to zero.

3.6

A Formans statement is correct. The variance would be predicted using the formula: t2 = ao + a12t-1 + ut

189

QUESTION 4 QUANTITATIVE METHODS

4.1 B The coefficient with the highest t stat will have the lowest p value. The t stat for the first coefficient is (b10)/SE. Thus (0.262-0)/1.763 = 0.148 4.2 A 128.54/3 (where k = 3) gives us mean sum of squares regression. Sum of square errors is the difference between the total sum of squares and the regression sum of squares, thus 131-128.54 = 2.46. Therefore the mean sum of square errors is 2.46/4 (where n-k-1=4). F test = MSSr/MSSe F test = 69.67 4.3 C 84.475 + (0.262 x 15) + (38 x 2.164) + (8 x 1.451) = 182.25 4.4 A Square root of mean sum of square errors. Using the information from the question: Regression sum of squares (RSS): 128.54 Total sum of squares (TSS): 131 we can calculate the sum of squares due to error as 131 128.54 = 2.46. We now need to divide this value by its degrees of freedom (n-k-1) thus 2.46/(8-3-1)=0.615. Finally we need the square root of 0.615, giving 0.7842 4.5 B I is the test for multicollinearity not conditional heterskedasticty. III if there are four seasons then we would need three dummy variables. 4.6 B Durbin Watson is used to test for serial correlation. The Breusch-Pagan test involves a Chi-squared test. The other test is to plot the variance of the error terms and see if there are constants.

190

QUESTION 5 ECONOMICS
5.1 B A flexible exchange rate would be freely floating and a pegged exchange rate freely floating within limits. A fixed exchange rate is constant but means that the smaller nation is tied to the economic policy of the larger.

5.2

A In order for PPP to predict the exchange rates, real exchange rates must stay constant. This is only likely to happen in the long term.

5.3

B 6.21 x (1 + 0.07 x 6 / 12) / (1 + 0.04 x 6 / 12) = 6.30

5.4

A Downward pressure on interest rates will lead to capital leaving the country and the currency depreciating. Domestic demand is likely to increase with more money available and lower interest rates, while the depreciating currency will eventually increase net exports.

5.5

C P = GDP x Earnings / GDP x P/E If GDP is growing at 8%, Earnings/GDP is static and P/E is growing, then P will grow at more than 8% In the long term, growth in P (which is dependent on the income generated) cannot exceed growth in potential GDP so Earnings/GDP and P/E are constant in the long term.

5.6

A Faster growth means that consumers will expect real income to rise rapidly and real interest rates will have to rise to attract savings. A higher growth rate improves the general credit quality of fixed income securities as most such securities are backed by a flow of income and this income stream is growing.

191

QUESTION 6 ECONOMICS
6.1 C High levels of savings and investment are required to increase capital and encourage growth.

6.2

A Access to, rather than ownership of natural resources is key to sustained growth.

6.3

C The endogenous growth theory holds that growth is endogenous in the economy and will continue perpetually. However, growth is still dependent on technological discoveries.

6.4

A Blintano is describing classical growth theory

6.5

B Steady state growth rate of output = [Growth rate of TFP/(1 )] + Growth rate labor Country A = (0.002/0.542) + 0.001 = 0.47% Country B = (0.015/0.519) + 0.004 = 3.29% Country C = (0.009/0.422) + 0.010 = 3.13%

6.6

B In steady state growth, the output-to-capital ratio is constant and the capital-to-labor ratio and output per worker grow at the same rate.

192

QUESTION 7 ECONOMICS
7.1 C Forward rates are calculated using interest rate differentials, not inflation differentials. A future spot rate is calculated using purchasing power parity, not covered interest rate parity. If interest rate parity, purchasing power parity and the International Fisher effect hold, then the forward rate should be the best unbiased predictor of the future spot rate 7.2 A Ethans conclusion about Swinflu Resorts local currency exposure is correct. A depreciation of the peso (appreciation of the U.S. dollar) leads to an increase in the peso value of Swinflus revenues (denominated in U.S. dollars). At the same time, Swinflus costs are denominated in pesos and are not affected by the exchange rate movement. Hence, all else equal, this will increase Swinflus profitability and share price, measured in pesos. Consequently there is a negative correlation between the value of the Mexican peso and Swinflu Resorts peso-based share price. 7.3 B The U.S. dollar holding period return that would result from the transaction recommended by Ethan is 2.5%. Taking a $1 investment, this can be converted at the spot rate into 9.5 pesos. This would yield 6.5% and give back 10.1175 pesos in one years time. This could then be converted back into dollars at the one year forward rate to give back $1.025 i.e. a 2.5% return. Ethans conclusion about the U.S. dollar holding period return is correct. 7.4 B Based on the International Fisher Effect:

1+ US interest rate 1+ US inflation = 1+ UK interest rate 1+ UK inflation

1.025 1.02 = 1.0489 1 + UK inf lation
UK Inflation = 0.04378 i.e. 4.4% Note that you could have made the comparison to the Mexican data and that would have given you the same answer

193

7.5

B
The expected exchange rate one year from now is 9.59.

9.50 x

1.03 = 9.59 1.02

7.6

A
Forward = $1.50 x 1.025 / 1.053 = $1.46 per 1

194

QUESTION 8 INTER-COMPANY INVESTMENTS

8.1 A If the consideration of 210,000 represented 75% of the company we can calculate the value of 100% of the company as 280,000. The fair value of the identifiable net assets is 185,000 since we need to include the R&D Full goodwill: 280,000 185,000 8.2 B Full minority interest: 0.25 x 280,000 Partial: 0.25 x 185,000 8.3 C Equity includes minority interest. Under US GAAP you have to use the full approach for minority interest. Thus equity will be parents equity + minority interest.

8.4

C C is the best available answer. Answer A is nearly correct expect for the word only re statement 3. Statement 3 is of course correct for both US GAAP and IFRS

8.5

B See Working 1 for details and notes below Working 1 Answer: Sales COGS Interest expense Depreciation expense Minority Interest Net Income IFRS and USGAAP 300,000 140,000 10,000 38,000 6,750 105,250

Under IFRS and US GAAP we recognized 100% of the excess fair value and so this will give us an extra depreciation expense of (100% x 80,000) / 10 = 8,000

8.6

C Equity will NOT be the same due to the impact of minority interest which is part of equity. Both methods account for fair value adjustments.

195

QUESTION 9 EMPLOYEE COMPENSATION

9.1 B 454m was the current service cost which represents the estimated increase in the pension obligation resulting from employees service during the period.

9.2

C Under IFRS, all service costs (past and current) are recognised in P&L, along with net interest (Net opening liability / Asset x Discount rate). Hence 454 + 76 + 14 = 544m

9.3

A Current service costs Interest expense on opening PBO Expected return on plan assets (5% x 15,082) Total 454 497 (754) 197m

9.4

C Increase in net liability = 49m This additional amount can be seen as an increase in the expense funded by borrowing from the pension fund as a loan. Hence increase CFF and decrease CFO by 49m

9.5

B The net interest cost is calculated using the discount rate applied to the opening benefit obligation. As the interest cost in the benefit obligation is 497, and the opening obligation 15,532, this is 497 / 15,532 = 3.2% Or using the opening position and net interest cost = 14 / 450 = 3.11% Note: This means return on assets included is 3.2% x 15,082 = 483. The difference between this 483 and the actual return on plan assets of 710 is 710 483 = 227 and is shown as a remeasurement gain.

9.6

C An increase in the dividend yield and a decrease in volatility would both reduce the value of the options.

196

QUESTION 10 F/X TRANSLATION

10.1 B Given the scenario we need to use the Temporal method. See Working 1 for full solutions

10.2

A The question is asking about the translation effect and not the transaction effect from exchange rate movements, thus C is wrong.

10.3

A Under US GAAP, foreign operations in hyperinflationary countries must use the temporal method. This is therefore the same as the given scenario, hence the loss will stay unchanged. Answer C is consistent with IFRS

10.4

B See working below.

10.5

10.6

C We would now use the All-Current method. See working below.

197

Initial B/S in Subsid in millions Cash Inventory PP&E Total assets Payables Common stock Retained earnings Total financing CTA Total 1.22 1.22 1.22 1.22 1.22 275 130 625 1030 250 780 0 1030

ALL-CURRENT 266 98 443 807 187 639 40 866 -58 807 1.34 1.22 RATE 1.34 1.34 1.34

31ST DEC LEV 357 131 594 1082 250 780 52 1082

TEMPORAL 266 107 487 861 187 639 35 861 1.34 1.22 RATE 1.34 1.22 1.22

31ST DEC LEV 357 131 594 1082 250 780 52 1082

Income Statement for year 1 (LEV millions) Sales COGS SGA Depreciation EBIT Interest Tax Profit before f/x gain/loss F/X gain/loss Net income 600 361 106 31 102 27 23 1.30 1.30 1.30 1.30 1.30 1.30

All-current EUR 461.54 277.69 81.54 23.85 78.46 20.77 17.69 1.30 1.30 1.30 1.30 1.30 1.22

Temporal EURO 461.54 277.69 81.54 25.41 76.90 20.77 17.69 38.44

0 52

0.00 40.00

-3.67 34.77

198

QUESTION 11 F/X TRANSLATION

11.1 A

Net Assets CASH INVENTORY PP&E NOTES PAYABLE Net Assets Net Monetary Assets CASH NOTES PAYABLE Net Monetary Assets 1,359 (1,000) 359 1100 520 2,500 (1,000) 3,120

11.2

C Given the scenario, we need to use the all-current method. Income statement is converted at the average rate for all items giving us a net income of 95 EUR. The balance sheet, is converted at the current (year-end) rate except for common stock which remains at the historic rate, giving us in Euros: Total assets Notes payable Common stock Retained earnings CTA Total financing 4,255 / 1.37 = 3,106 1,000 / 1.37 = 730 3,120 / 1.56 = 2,000 135 / 1.42 = 95 281 3,106

Total assets and notes payable are converted at the current rate. Common stock is translated at the historic rate. Retained earnings consists of the net income for the first year of operation at the average rate. The CTA is the balancing figure.

199

11.3

B The auditors suggestion would mean using the temporal method to account for Dartner USA. To calculate the exchange gain/loss we first convert the balance sheet using year-end rates for monetary items (cash and payables) and historic for everything else. Retained earnings is calculated as the balancing figure.

Cash Inventory PP&E Total assets Notes payable Common stock Retained earnings Total financing

1359/1.37 520/1.56 2376/1.56 1,000/1.37 3,120/1.56

992 333 1523 2848 730 2,000 118 2848

Retained earnings must be equal to net income for the year as there are no dividends paid for the year. Note that the company uses LIFO to account for inventory, so the ending inventory is made up of the oldest items. As there are the same number of units in inventory at the year-end as at the start, the ending units will be the units that were in inventory at the start of the year. Hence their historic cost is 1.56. Income Statement SALES COGS SG&A DEPRECIATION EBIT INTEREST TAX NET INCOME F/X gain Net income 2,200/1.42 (1,420)/1.42 (300)/1.42 (140)/1.56 (115)/1.42 (90)/1.42 1,549 (1,000) (211) (90) 248 (81) (63) 104 14 118

(from balance sheet)

As opening and closing inventory was identical, the COGS figure is made up of purchases alone, which is translated at average rate.

11.4

B Net margin is a pure ratio i.e. income statement/income statement. Both numbers will therefore be translated at the same (average) rate and hence the ratio will be identical in the local and reporting currency.

200

11.5

A Dividends are always translated at the historic rate under either method. If the local currency is strengthening then the most recent dividend will be larger when translated into the reporting currency.

11.6

B If the subsidiary has net monetary asset, a gain will be reported in the income statement when the local currency strengthens. If the reporting currency is weakening, then this means that the local currency is indeed strengthening and gains will be reported. There is no cumulative translation adjustment under the temporal method. If the local currency weakens, then the parent will experience exchange rate gains if the local currency weakens.

201

QUESTION 12 EARNINGS QUALITY

12.1 C NOA = Total assets (excluding cash and short term investments) Total liabilities (excluding debt) Year 1 NOA = 52+33+205+30-25-22-22-25 = 226 Year 2 NOA = 76+46+250+65-40-44-31-15 = 307

12.2

C CF approach: Net income (CFO + CFI) = 190 (166 60) = 86

12.3

A Balance sheet aggregate accruals = change in Net Operating Assets = 309 210 = 99

12.4

C Where Accruals ratio = aggregate accruals/average net operating assets In this example: 99/[(210+309)/2] = 0.3815

12.5

A The higher the aggregate accruals, the lower the earnings quality

12.6

C Increase in net receivables Increase in deferred revenue (short term and long term) (76 - 52) - [(31 + 15) - (22 + 25)] = 24 + 1 = 25

202

QUESTION 13 CORPORATE FINANCE

13.1 A

Recovery WC Sale Proceeds Tax Proceeds Tax Base Taxable Gain Tax @ 40%

20,000 25,000 25,000 15,000 10,000 -4,000 41,000

13.2

B Tax Calculation Sales 250,000 Exp (152,000) Depn (41,000) Taxable Inc. 57,000 Tax at 40% (22,800) Cash Flows 250,000 (152,000)

Sales Exp

Tax OCF

(22,800) 75,200

13.3

C Under Modigliani and Millers theory with tax, the value of the tax shield increases the value of a leveraged company compared to an unleveraged one.

13.4

A In Reason 2, capital growth is not certain and the bird in the hand theory states that investors prefer the certainty of a cash dividend rather than the uncertainty of a future capital gain.

13.5

B Investors facing a marginal tax rate on capital gains lower than that on dividends will benefit from the repurchase of shares which will defer a capital gain rather than a dividend.

13.6

C Policy I describes a dividend which will vary with earnings. Policy II is not sustainable in the long term

203

QUESTION 14 CORPORATE GOVERNANCE

14.1 B Stock options ought to help align the interests of the management with those of the shareholders.

14.2

B Specialist committees such as the audit committee should consist of those with the relevant technical background.

14.3

C Best practice requires such meetings are held at least annually and preferably quarterly

14.4

C Bonuses should be paid for exceeding expected long term company performance

14.5

B Nominating committee is there to screen prospective candidates and to put forward to the board of limited choice of candidates. It is the Board that ultimately selects.

14.6

A The other risks could be accounting risk (i.e. dodgy accounts) and strategic risks (i.e. empire building).

204

QUESTION 15 EQUITY
15.1 B Value after transaction = 232+42+7.8-45.8 = 236.0m Gain to target = 45.8m 42m = 3.8m

15.2

B Value after transaction = 232+42+7.8 = 281.8m No shares in issue 5,800,000 + 1,200,000 = 7,000,000. Share Price = 281.8m/7.0m = $40.26 Gain to target = ($40.26 x 1,200,000) - $42m = $6,312,000 Gain to Acquirer = 7,800,000 6,312,000 = 1,488,000

15.3

C Elitetric is a supplier, and hence BTN is acquiring a company in its supply chain. This is a vertical merger.

15.4

C Cost of equity = 2.8% + (1.3x6%) + 3% = 13.6% Cost of debt = 8% x 0.6 = 4.8% WACC = (13.6 x 0.7) + (4.8 x 0.3) = 10.96%

15.5

A The discounts are multiplicative; 1 (1-0.2)(1-0.25) = 40%

15.6

A There is no discount for lack of control required if 100% of the share capital is to be acquired, as the acquirer will gain control. Note, the valuation using the guideline transactions method will include a premium for control, so there is no need to include a control premium

205

QUESTION 16 EQUITY
16.1 C (see working below)

16.2

A (see working below) m Discount rate Sales (25% growth pa) Net income (30% of sales) Capex (40% of sales) Depreciation (8% of sales) Working capital investment(6% of sales) New debt 40% D/TA FCFE= NI +Dep-WC-Capex +new debt FCFE = NI - (1-0.4)(Capex - Dep + WC inv) PV OF FCFE (at 15%) Terminal value (14 X E5) PV of terminal value Value of firm Share price Number of shares 1 15% 3.50 1.05 1.40 0.28 0.21 0.53 0.25 0.25 0.22 35.89 17.84 19.15 1.91 10 2 4.38 1.31 1.75 0.35 0.26 0.67 0.32 0.32 0.24 3 5.47 1.64 2.19 0.44 0.33 0.83 0.39 0.39 0.26 4 6.84 2.05 2.73 0.55 0.41 1.04 0.49 0.49 0.28 5 8.54 2.56 3.42 0.68 0.51 1.30 0.62 0.62 0.31

Tutor Tip. Having been given year 1 FCFE you can easily calculate the other years by growing this by 25% p.a.

16.3

A FCF valuation is a controlling valuation whereas stock markets quote price of single (minority interest) shares.

16.4

C Neither method is better than the other for a standalone perspective.

206

16.5

Both statements are correct.

16.6

B Deferred tax which is expected to reverse out in the near future is ignored.

207

QUESTION 17 EQUITY
17.1 B Unlevered beta: 1.1 / (1+0.45) = 0.7586. D/E ratio of PBI = 90/(345-90) = 0.3529 Levered beta for PBI = 0.7586 x 1+0.3529 17.2 A CAPM uses a T-Bond yield as the risk-free, thus r = 4 + 1.3 x (8 4) = 9.2 Therefore leading P/E = (1-b)/(r-g), where 1-b = payout ratio. Thus 0.6/(0.092- 0.06) = 18.75x 17.3 A Fama-French uses the T-Bill yield whereas CAPM uses the 10y T-Bond yield. The final variable is not liquidity but represents the book to market value. 17.4 C B0 + RI1/(r - g). Given the total assets and the debt we know that equity (and therefore book value) is 255. Residual Income is ( ROE r) x opening book value (0.14 0.11) x 255 = 7.65. Alternatively we can calculate RI as 35.7 (0.11 x 255). Therefore : 255 + 7.65/(0.11 0.06) = 408 17.5 C Marginal tax rates are the most appropriate tax rate to use. 17.6 C First we need to calculate the share price: D1/(r-g) where D1 is payout ratio x net income for Yr 1. We are given current net income therefore we need to grow this one year: 35.7 x 1.06 = 37.84. Thus (0.6 x 37.84)/ (0.09 - 0.06) = $756.84 Therefore 756.84 = E1 + PVGO r E1 i.e. 35.7 x 1.06 = 420.47 so PVGO 336 r 0.09

208

QUESTION 18 FREE CASH FLOW (partial item set)

18.1 B The assets of the company have risen by : 12 + 3 6 = 9 This needs to be financed by a mixture of debt and equity. Given the D/E ratio the amount that is debt financed is 37.5% therefore new debt equals $3.375m FCFE = 20 +6 -12 -3 +3.375 = $14.375 Alternatively: NI (1-DR)(Capex - Depreciation + Increase in WC) where DR is D/TA ratio. In this example DR = 0.375 20 (1-0.375)(12 6 + 3) = 14.375

18.2

A FCFF = 20 + 6 -12- 3 + (3 x 0.75) = $13.25 Or FCFE + post-tax interest - New debt

18.3

A FCFE: 7 (FCFF) - (3 x 0.7) 2 (pref div) + 1 = $3.9m Or could calculate Net Income from information provided and then use the traditional approach. See below for workings for FCFF

18.4

B FCFF = (12 x 0.7) + (2 x 0.3) 3 + 1 = $7m

209

QUESTION 19 RESIDUAL INCOME QUESTION

19.1 19.2 19.3 19.4 A B A B Answer C is in fact a strength of this model. 19.5 A Both B/S and I/S need adjusting. The present value of EVA can be used to calculate the market value added but does not directly give the value of equity. 19.6 B If ROE is greater than required return, residual income is positive. Sales (30% growth pa) Net income (35% of sales) Cost of equity 12% Opening book value Dividends (20%) Closing BV Residual income PV OF RI Sum of PV PV of TV Price Terminal value PV OF TV Price Assume perpetuity PV of TV Price 30.86 18.83 26.29 14.912 19.35 5.08 2.881 Assume persistence factor OF 0.4 5.94 6 3.40 5.50 1.93 1 12% 10 0.385 11.54 0.73 0.65 7.15 2.50 2 11.54 0.5005 13.54 1.12 0.89 9.30 3.25 3 13.54 16.14 1.63 1.16 12.08 4.23 4 16.14 19.53 2.29 1.46 15.71 5.50 5 19.53 23.93 3.15 1.79

0.65065 0.845845 1.099599

210

1.

Residual income in period is 3.66. TV = 3.66 / 1.12 0.4 = 5.08. The TV calculation gives us a value as at time 5. The TV of 5.08 is thus discounted by 5 years. The share price will therefore be the PV of Residual Income for years 1 5 plus the PV of the terminal value. Here we have started the perpetuity in year 6 as directed in the assumption, thus the terminal value of 26.25 is a value as at year 5. If we discount this back by 5 years we get 14.91. If we then add the PV of residual incomes for years 1-5 we get the stock price. Alternatively we could have started the perpetuity in year 5 which would give us a TV in year 4. If we discount back by 4 years and add the PV of the RIs for years 1-4 we would get the same answer.

2.

211

QUESTION 20 PRIVATE EQUITY VALUATION

20.1 B Alexander Howe has less incentive to take excessive risk, since he will share in the losses of the fund, whereas the managers of Beta Fund will not.

20.2

A DCA appears to be a global macro fund, therefore it is most likely to have exposure to negative asymmetrical beta, with lower betas in rising markets and higher betas in falling markets. A dedicated short bias fund such as High Clear has the opposite exposure, with higher betas in rising markets and lower betas in falling markets (since their risk exposure is higher in rising markets because of unlimited downside). Market neutral equity funds such as Purfleet capital have little exposure to asymmetrical beta because of the strategy to remain neutral.

20.3

C Private equity firms are able to access credit markets on favorable terms and also re-engineer a companys operations to increase returns. Focusing on short term goals to increase shareholder wealth is generally a characteristic of firms that are listed on public security exchanges, as these companies generally have to appease shareholders.

20.4

C The paid in capital to date is called the PIC. The DPI (Distributed capital paid in) is the cumulative distributions paid out to LPs as a proportion of cumulative invested capital. The DPI is the cash on cash multiple, not the PIC. The second statement is true.

20.5

A Term Rent PV at 3% Reversion to ERV Value of perpetuity PV today Total Value 320,000 612,310 372,500 372,500/0.05 = 7,450,000 7,450,000/1.052

6,757,370 7,369,680

20.6

B Regular re-election of board members is considered to be good corporate governance for listed companies. However, private equity firms will generally work with a tried and tested management team and are unlikely to want to change these over the term of their investment.

212

QUESTION 21 CONVERTIBLE BONDS

21.1 A Minimum price is the higher of an equivalent straight bond or the conversion value. Straight bond is $98.5 per $100 par. Conversion value is 5 x 18 = $90 per $100 par.

21.2

B Implied conversion price is Price of convertible / Conversion terms. Convertible bond is priced at $98.9 per $100 par. Therefore 98.9/5 = $19.78 giving us a premium to the current stock price of $1.78. The conversion premium percentage is thus 1.78/18 = 9.88%

21.3

A Bond pays 8% x Par = $8 per $100 Stock pays div of $0.801 per share. (derived from div yield).Therefore difference is 8 (5x0.801) = $3.995 per $100 par.

21.4

C Conversion premium per share/income differential per share. 1.78 / (3.995/5) = 2.23 years

21.5

A Increase in stocks volatility will increase the value of the embedded option within the convertible. Decrease in interest volatility will reduce the value of the embedded option within the callable bond. The investor is long the call option on equity and short the call option on the bond hence the bond should rise in value

21.6

B The embedded option in the convertible (call option on stock) is likely to have a delta of less than one therefore the convertible will rise by less than the underlying stock.

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QUESTION 22 BINOMIAL BOND PRICING

22.1 A

If we price a BBB putable bond using risk free rates then the price we calculate in the model will be too high compared with the market price. To bring the model price down to the market price we need to apply a spread (OAS) to the rates in the tree. When we increase the volatility in the model this model price will increase even higher. Thus the move the model price down to the market price we will need an even bigger OAS.

22.2

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22.3

B There is considerable uncertainty when valuing a MBS and this uncertainty (called Model Risk) needs to be allowed for. Higher uncertainty equates to a higher spread over the benchmark.

22.4

22.5

C MBS (and Home Equity Loans) require a forward looking model since the cashflows are interest rate path dependent. A backward approach used in the binomial model would be unsuitable.

22.6

B Statement I is incorrect because the PSA must stay within and be constant for the cash flows to be as planned. Statement IV is incorrect because it depends upon the effective collar.

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QUESTION 23 FIXED INCOME

23.1 B The manager is covering the floating payments to the senior tranche with floating receipts on the swaps. Fixed receipts on the bonds cover the fixed payments on the swap 23.2 C Cash CDO will hold a portfolio of bonds whereas synthetic CDOs will use credit default swaps

23.3

B Note we are given the pool factor which is Opening Balance/Initial balance hence the opening balance for month 3 is 99,588.28. See working 1. .

23.4

C See working 1

23.5

C All three tranches have very similar OAS and yet tranche 3 has considerably higher duration. Given the higher risk, you would expect a significantly higher OAS.

23.6

A MBS is similar to a callable bond in that the investor has no control over the speed of principal payments. Given this risk, the Z spread should be higher than the OAS. If we increase our assumption of volatility in our model (obviously our own model will not affect the market price of the bond) then the price we arrive at in our model will be lower than before. In other words the difference between our model price using benchmark rates and the actual market price (which is lower due to differences in credit and liquidity risk) will now be less, hence the adjustment needed to the interest rate tree to derive the market price will also be less. Working 1 Opening 100000.00 99828.01 99588.28 CPR 0.008 0.016 0.024 Interest 666.67 665.52 663.92 SMM 0.0006691 0.0013432 0.0020223 Payment -771.82 -771.30 -770.26 N 300 299 298 Scheduled balance 99894.85 99722.23 99481.94 Time periods 1 2 3 Prepay ment 66.84 133.95 201.19 Closing balance 99828.01 99588.28 99280.75

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QUESTION 24 DERIVATIVES
24.1 B Using the following formula: Forward Price = (Spot PV Cash flow) (1+r)T 3 month Forward Price = 68 0.42 1.0271/12 3 month Forward Price = $68.03 x (1.027)3/12

24.2

A Vt = (St PV of remaining cash flows) PV of Forward Vt = (72 0) 69.03/ 1.029 1/12 Vt = + 3.13 therefore the investors who sold this equates to a loss of 3.13

24.3

C Value of the forward contract at expiration for the LONG = price of underlying asset Forward Contract price. Note the information given states that this forward was originally sold. V = $55.00 $72.00 = -$17.00 therefore this equates to a gain of 17 for the short. Question 4 and 5 Extract 1 Incorrect It will rise Extract 2 Correct It will rise Extract 3 Incorrect It will rise Extract 4 Correct It will rise Extract 5 Correct It will rise Extract 6 Incorrect It will rise Extract 7 Incorrect highest at the money, close to expiration

24.4 24.5

B A

See above See above.

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24.6

C Using Put/Call Parity P = C S + PV(Bond) P = 30 100 + 120e-(0.05/2) P = $47.037 The fair value of the Put is $47.037. As the market price of the put is higher, we should sell the put and use Put/Call parity to lock in an arbitrage profit by buying a synthetic put at the cheaper price of $47.037 Therefore we should sell the Put and buy a call, sell the stock and lend the present value of the strike (Buy a bond). This would give a profit of 48-47.037 = 0.963 This technique works no matter which element you calculated as the subject of the equation.

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QUESTION 25 DERIVATIVES
25.1 C First we need to deannualise the rates 270 day = 1+ (0.06x270/360) = 1.045 90 day = 1 + (0.0275 x 90/360) = 1.006875 Therefore a 3x9 FRA will be [1.045/1.006875 ] -1 = 0.03786. Last step is to annualise this rate: 0.03786 x 360/180 = 0.0757

25.2

A The value will be the Net Present Value. We know what the FRA rate is i.e. 7.4% we now need to calculate what LIBOR will be at the effective date. In other words we need to calculate a forward LIBOR rate using the technique from the previous question. As in the example above we use money market conventions. The value at t30 = PV of the FRA payoff. The FRA payoff is calculated as at time180 = (180 day LIBOR FRA) x 18/360 x notional principal. We need to calculate the forward 180 LIBOR commencing in 150 days time. [1+ de-annualised 330 LIBOR/ 1+ de-annualised 150 LIBOR] -1 x 360/180 = 5.7% Payoff at time180 = (0.074 0.057) x 180/360 x 1m = 8,500 PV this amount back to time30 = 8,500/1+(0.0475 x 330/360) = 8,145

25.3

C Eurodollar futures are priced 100 implied interest rate. Thus, if interest rates rise then the price will fall. If you are long then you will make a loss if interest rates rise.

25.4

B The basic model assumes no cash flows from the underlying. Note, that this assumption can be relaxed. Conversation I is incorrect since we assume the returns follow a lognormal distribution. Statement II is incorrect since BSM only values European options. Statement IV is incorrect since BSM assumes constant volatility of the underlying which is not the case with bonds (duration falls as near maturity)

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25.5

A Higher the strike of a call, the lower the price. European style put options can exhibit negative time value. Therefore, it is possible for a longer dated put option to be cheaper than an equivalent shorter dated put option.

25.6

C First we need to calculate the discount factors using the de-annualised rates of interest. 180 day LIBOR Discount factor = 0.04 x 180/360 = 0.02 = 1/ 1.02 = 0.9804 360 day LIBOR Discount factor = 0.045 x 360/360 = 0.045 = 1/1.045 = 0.9569 Fixed rate = 1 - 0.9569 0.9804 + 0.9569 = 0.0222 This fixed rate is quoted by annualising using money market conventions (swaps always use 360 convention) = 0.0222 x 360/180 = 4.45%

220

QUESTION 26 DERIVATIVES
26.1 A F (0,300) = [Spot price (full price) PV cash flows prior to expiry] x (1 + r) ^ 300/365 Note: we assume a semi-annual bond. [1052.10 78.39] x 1.06 ^ 300/365 = 1021.47 PV of cashflows = 40/1.06 ^ 37/365 + 40/1.06^219/365 = 78.39 26.2 A There is now only one cash flow to consider prior to the expiry of the forward. This cash flow will now be in 159 days time. PV of cash flow = 40/1.07^159/365 = 38.84 Value of F = [1029.32 38.84] 1020.05/1.07^240/365 = 14.8 Note the value is calculated from the buyers perspective. 26.3 A First we need to calculate the Hedge ratio = C+ - C- / S+ - S10 - 0 / 70 - 40 = Therefore 3 x calls = 1 stock Hence our risk-free portfolio will be Stock 3calls. Now we need to calculate the value of the risk free portfolio at the end of the first time period. If price rises the value : 70 (3 x 10) = 40 (calls will be exercised yielding a loss to the writer of 10 per option) If price falls : 40 (3 x 0) = 40 0.333

Therefore the initially risk-free portfolio will be worth $40 at the end of the first time period. We must now calculate the present value of this portfolio. Stock 3C = PV of 40 50 3C C = 3.968 Alternatively we could use the risk neutral probabilities method = 40 / 1.05

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26.4

A Using discrete time periods. The basic put-call parity formula is: Discrete version: C P = S PV of X

4 - 11 + 60/1.05 = S = $50.14

Therefore we need to sell the synthetic and buy the stock. This means we need to rearrange the formula to arrive at S thus: -S = P C PV of X In words this is long put, short call and short bond 26.5 C Deeply ITM American style puts will always have a lower value as time to expiry shortens. This is not however true for European put options As the underlying rises the options will become less ITM and more OTM and hence its delta will tend to zero Volatility affects all options in a direct way thus if it is rises then so will the option value. Cash flows from the underlying that arise prior to expiry also have a direct impact on put options. 26.5 B Delta and rho of a long call will be positive however theta will be negative.

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QUESTION 27 INVESTMENT POLICY STATEMENT

For the rationale for the answers see the table below. 27.1 27.2 27.3 27.4 27.5 C See below C See below (The ability to take risk dominates over the willingness) C See below C See below C only ii & iii are constraints as per the text. Time Horizon, Taxes, Liquidity, Legal Regulatory, Unique Circumstances

27.6

C Ability to take Risk Positive Time horizon Immediate need for an income 6 month holiday home 16 year time horizon to fund education costs. 26 year time horizon until retirement. 65 death Overall - long Health Both in good health, including parents, may suggest need to provide income/other expenses for a long period once retired. Wealth Levels The inheritance has considerably transformed the clients ability to take risk. However no other source of wealth, this portfolio is their only financial asset outside the business. At retirement this business asset is intended to be sold and if a successful sale is achieved will provide a major boost to retirement capital. Returns Required Living expenses required after tax 47k An after-tax return of 3.76% (47k/1.25m). Liquidity Clients want to draw a net after tax income of 47k to fund their living expenses. Short-term 250k needed in 6mths. Education in 16 years -250k Retirement 26 years no pensions Business profits volatile due to sensitivity to economy & weather. Suggests may be additional need for liquidity in quiet periods. The clients also do not have any other investments to fall back on. They are essentially undiversified and have a concentrated exposure to the restaurant trade. Suggests a greater need for liquidity as they have no other source in the event of an unexpected event. Liquidity also needed in 16 years for education costs. Living expenses vs. Income They have previously found it difficult at times to fund their living expenses due to the variability of their business income. This volatility suggests a greater need for flexibility in liquidity to assist in times of a downturn in business fortunes. They now wish to take an income of 47k. With a young child their Ability to take Risk Negative

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Allowing for inflation at 2.2% can be calculated either by compounding or adding. 1.0376 x 1.022 = 6.04% or 3.76 + 2.2 = 5.96% (Compounding preferred method). This should be achievable over the stated time horizon. Allowing for tax: 6.04 x 100/(100 40) = 10.07% or 5.96 x 100/(100-40) = 9.93% Clients also have a need to fund Donatellas education, and their own retirement. The long term nature of these objectives suggest a requirement to achieve growth from their capital as well as fund their income needs. By not drawing an income from their business they are effectively growing this business asset also and will be able to start drawing an income in the future and have the flexibility to manage this in line with their spending needs.

spending is very likely to increase so additional liquidity may be needed. Future Wealth Businesses are unpredictable, difficult to be certain of selling a business many years ahead. Uncertainty. Potential for a lack of retirement capital and income at age 65.

Overall ability to take risk below average The immediate liquidity needs, together with the lack of any other investments/source of liquidity, and the variability of the business profits indicate a lower than average ability to take risk. This is balanced by effectively growing their business by not taking profits, there is always the potential to start drawing profits in the future. Also the longer time horizon and the requirement for growth as well as income dictates a need for some risk in longer term equities. Overall below average ability Attitude to equities They like the idea of investing in equities, family experience of equities although no experience themselves. Previous Risk Taking They have been in business for 5 years and as such are used to taking risks. Especially as their business has volatile profits and is subject to considerable fluctuations in income. This experience of volatility shows a willingness to accept risk. Overall willingness to take risk above average The clients have taken risks setting up their own business and they have a 5 year record themselves and experience within a family business for a longer period. They work in a volatile market, where income does fluctuate and so understand the impact that volatility can have. They have little experience of investment risk however with no investments currently. They express an interest in equities and like the idea of equity based investments and seem to show an interest in Previous experience of investment No previous direct investment experience, only via their business, or via family members.

224

investment. Overall therefore an above average willingness to take risk.

Overall, the ability to take risk must dominate when assessing the overall risk tolerance. Therefore the clients have a below risk tolerance, currently dominated by a high income need

225

QUESTION 28 PORTFOLIO MANAGEMENT

28.1 B Using the two asset portfolio standard deviation formula. X+A = WX2 x X2 + WA2 x A2 + 2 x WX x WA x X x A x CorX + A WX Weight in Portfolio X. WA - Weight in Portfolio A X - Standard deviation of Portfolio X A - Standard deviation of Portfolio A CorX+A Correlation between Portfolios X and A The combinations produce the following Portfolio Standard Deviations: Portfolio X + A = 10.2% Portfolio X + B = 10.68% Portfolio X + C = 10.36%

28.2

RP = w1R1 + w2R2 + w3R3

2 2 2 2 2 2 P = w1 1 + w2 22 + w33 + 2w1w2Cov1,2 + 2w1w3Cov1,3 + 2w2 w3Cov2,3 2 2 2 2 2 = w1 1 + w2 22 + w33 + 2w1w21,212 + 2w1w31,313 + 2w2 w32,323

= 63.05 + 13.64 + 14.59 + 7.84

28.3

C CovarianceX + C = CorrX+C x X x C CovarianceX + C = 0.29 x 0.12 x 0.14 = 0.004872

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28.4

B Portfolio risk as a % variance = [((1 - r) / n) + r ] x Average variance Where r=average correlation. Using the variances given in the question of 121 (standard deviation is 11) we can calculate the value for n.

28.5

B Minimum risk would be where n becomes infinite thus the first part of the equation shown in answer 4 will become zero, meaning the portfolio risk becomes just r x average risk. Thus 0.3 x 388 = 116.4 which gives a standard deviation of 10.788

28.6

C First we need to calculate the Sharpe ratio of Portfolio A: (8.6 - 4.55)/11 = 0.368 If the Sharpe ratio of the new asset is greater than Sharpe of existing x correlation with new asset then accept. Thus 0.368 x 0.25 = 0.09 Therefore accept the new asset

227