uk l2 review course solutions 2013 v1-1.1

7/30/2019 UK L2 Review Course Solutions 2013 V1-1.1

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185

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 theanalysis 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 beneficiariesare 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 tobenefit another client so long as this is disclosed. Whereas with principal trades disclosure is not sufficient

must also gain consent.


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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 arelooked 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.


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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 isallowed 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 e-

mailed 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 futurecommunications.

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.


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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 A


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QUESTION 3 QUANTITATIVE METHODS

3.1 BThe coefficient of determination, R squared, is SSR/SST which is the sum of squared regression over thetotal sum of squares. This means that the independent variables explain 82% of the total variation in the

dependent variable.

3.2 AConditional 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 BDurbin Watson cannot be used for autoregressive models.

3.5 CIf 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 AFormans statement is correct. The variance would be predicted using the formula:

t2 = ao + a1

2t-1 + ut


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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 (b1-0)/SE. Thus (0.262-0)/1.763 = 0.148

4.2 A128.54/3 (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 C84.475 + (0.262 x 15) + (38 x 2.164) + (8 x 1.451) = 182.25

4.4 ASquare 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 BI is the test for multicollinearity not conditional heterskedasticty.

III if there are four seasons then we would need three dummy variables.

4.6 BDurbin 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.


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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 thelarger.

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.


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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.


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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:

inflationUK1

inflationUS1

rateinterestUK1

rateinterestUS1

+

+=

+

+

lationUK inf1

02.1

0489.1

025.1

+=

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


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7.5 B

The expected exchange rate one year from now is 9.59.

59.902.1

03.150.9 =x

7.6 A

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


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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 thecompany 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: IFRS and USGAAP

Sales 300,000

COGS 140,000

Interest expense 10,000

Depreciation expense 38,000

Minority Interest 6,750Net Income 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.


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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 PBOExpected return on plan assets (5% x 15,082)

454

497(754)

Total 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.


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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 C

10.6 C

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


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Initial B/S in Subsid in millions ALL-CURRENT 31ST DEC TEMPORAL

31ST

DEC

RATE LEV RATE LEV

Cash 1.22 275 266 1.34 357 266 1.34 357

Inventory 1.22 130 98 1.34 131 107 1.22 131

PP&E 1.22 625 443 1.34 594 487 1.22 594

Total assets 1030 807 1082 861 1082

Payables 1.22 250 187 1.34 250 187 1.34 250

Common stock 1.22 780 639 1.22 780 639 1.22 780

Retained earnings 0 40 52 35 52

Total financing 1030 866 1082 861 1082

CTA -58 Total 807

Income Statement for year 1 (LEV millions) All-current Temporal

EUR EURO

Sales 600 1.30 461.54 1.30 461.54

COGS 361 1.30 277.69 1.30 277.69

SGA 106 1.30 81.54 1.30 81.54

Depreciation 31 1.30 23.85 1.22 25.41

EBIT 102 78.46

76.90Interest 27 1.30 20.77 1.30 20.77

Tax 23 1.30 17.69 1.30 17.69

Profit before f/x

gain/loss 38.44

F/X gain/loss 0 0.00 -3.67

Net income 52 40.00 34.77


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QUESTION 11 F/X TRANSLATION

11.1 A

Net Assets

CASH 1100

INVENTORY 520

PP&E 2,500

NOTES PAYABLE (1,000)

Net Assets 3,120

Net Monetary Assets

CASH 1,359

NOTES PAYABLE (1,000)

Net Monetary Assets 359

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 4,255 / 1.37 = 3,106

Notes payable 1,000 / 1.37 = 730

Common stock 3,120 / 1.56 = 2,000

Retained earnings 135 / 1.42 = 95

CTA 281

Total financing 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.


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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 monetaryitems (cash and payables) and historic for everything else. Retained earnings is calculated as the balancing

figure.

Cash 1359/1.37 992

Inventory 520/1.56 333

PP&E 2376/1.56 1523

Total assets 2848

Notes payable 1,000/1.37 730

Common stock 3,120/1.56 2,000

Retained earnings 118

Total financing 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 2,200/1.42 1,549

COGS (1,420)/1.42 (1,000)

SG&A (300)/1.42 (211)

DEPRECIATION (140)/1.56 (90)

EBIT 248

INTEREST (115)/1.42 (81)

TAX (90)/1.42 (63)

NET INCOME 104

F/X gain 14

Net income (from balance sheet) 118

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.


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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.


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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

WhereAccruals 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


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QUESTION 13 CORPORATE FINANCE

13.1 A

Recovery WC 20,000

Sale Proceeds 25,000Tax Proceeds 25,000

Tax Base 15,000

Taxable Gain 10,000

Tax @ 40% -4,000

41,000

13.2 B

Tax Calculation Cash FlowsSales 250,000 Sales 250,000

Exp (152,000) Exp (152,000)

Depn (41,000)

Taxable Inc. 57,000

Tax at 40% (22,800) Tax (22,800)

OCF 75,200

13.3 C

Under Modigliani and Millers theory with tax, the value of the tax shield increases the value of a leveragedcompany 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


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QUESTION 14 CORPORATE GOVERNANCE

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

14.2 BSpecialist 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).


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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


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QUESTION 16 EQUITY

16.1 C (see working below)

16.2 A (see working below)

m 1 2 3 4 5

Discount rate 15%

Sales (25% growth pa) 3.50 4.38 5.47 6.84 8.54

Net income (30% of sales) 1.05 1.31 1.64 2.05 2.56

Capex (40% of sales) 1.40 1.75 2.19 2.73 3.42

Depreciation (8% of sales) 0.28 0.35 0.44 0.55 0.68

Working capital investment(6% of sales) 0.21 0.26 0.33 0.41 0.51

New debt 40% D/TA 0.53 0.67 0.83 1.04 1.30

FCFE= NI +Dep-WC-Capex +new debt 0.25 0.32 0.39 0.49 0.62

FCFE = NI - (1-0.4)(Capex - Dep + WC inv) 0.25 0.32 0.39 0.49 0.62

PV OF FCFE (at 15%) 0.22 0.24 0.26 0.28 0.31

Terminal value (14 X E5) 35.89

PV of terminal value 17.84

Value of firm 19.15

Share price 1.91

Number of shares 10

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.


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16.5 A

Both statements are correct.

16.6 B

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


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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

rE1 i.e. 35.7 x 1.06 = 420.47 so PVGO 336

r 0.09


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QUESTION 18 FREE CASH FLOW (partial item set)

18.1 B

The assets of the company have risen by : 12 + 3 6 = 9This 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. Seebelow for workings for FCFF

18.4 B

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


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QUESTION 19 RESIDUAL INCOME QUESTION

19.1 A

19.2 B

19.3 A

19.4 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) 5.50 7.15 9.30 12.08 15.71

Net income (35% of sales) 1.93 2.50 3.25 4.23 5.50

1 2 3 4 5

Cost of equity 12% 12% Opening book value 10 11.54 13.54 16.14 19.53

Dividends (20%) 0.385 0.5005 0.65065 0.845845 1.099599

Closing BV 11.54 13.54 16.14 19.53 23.93

Residual income 0.73 1.12 1.63 2.29 3.15

PV OF RI 0.65 0.89 1.16 1.46 1.79

Sum of PV 5.94

6

PV of TV 3.40

Price 19.35

Assume persistence factor OF 0.4

Terminal value 5.08

PV OF TV 2.881

Price 18.83

Assume perpetuity 26.29

PV of TV 14.912

Price 30.86


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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.

2. 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 theperpetuity 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.


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QUESTION 20 PRIVATE EQUITY VALUATION20.1 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 320,000

PV at 3% 612,310

Reversion to ERV 372,500

Value of perpetuity 372,500/0.05 = 7,450,000PV today 7,450,000/1.052 6,757,370

Total Value 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.


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QUESTION 21 CONVERTIBLE BONDS

21.1 A

Minimum price is the higher of an equivalent straight bond or the conversion value. Straight bond is $98.5per $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 willbe 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 A


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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 B

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 1Opening Interest Payment Scheduled

balance

Prepay

ment

Closing

balance

100000.00 666.67 -771.82 99894.85 66.84 99828.01

99828.01 665.52 -771.30 99722.23 133.95 99588.28

99588.28 663.92 -770.26 99481.94 201.19 99280.75

CPR SMM N Time periods

0.008 0.0006691 300 1

0.016 0.0013432 299 2

0.024 0.0020223 298 3


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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 x (1.027)3/12

1.0271/12

3 month Forward Price = $68.03

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 7 Incorrect highest at the money, close to expiration

24.4 B See above

24.5 A 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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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 putoption.

25.6 C

First we need to calculate the discount factors using the de-annualised rates of interest.

180 day LIBOR = 0.04 x 180/360 = 0.02

Discount factor = 1/ 1.02

= 0.9804

360 day LIBOR = 0.045 x 360/360 = 0.045

Discount factor = 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%


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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+ - S-

10 - 0 / 70 - 40

= 0.333Therefore 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

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 = 40 / 1.05

C = 3.968

Alternatively we could use the risk neutral probabilities method


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26.4 A

Using discrete time periods.

The basic put-call parity formula is: C P = S PV of X

Discrete version: 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 nothowever 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 C See below

27.2 C See below (The ability to take risk dominates over the willingness)

27.3 C See below

27.4 C See below

27.5 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 Ability to take Risk Negative

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 deathOverall - 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 transformedthe 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 pensionsBusiness 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 anincome of 47k. With a young child their


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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 becertain 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 averageability

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 theirbusiness has volatile profits and is subject to

considerable fluctuations in income.

This experience of volatility shows a willingness

to accept risk.

Previous experience of investment

No previous direct investment experience, only

via their business, or via family members.

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


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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


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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 A

= + +

= + + + + +

= + + + + +

P 1 1 2 2 3 3

2 2 2 2 2 2 2P 1 1 2 2 3 3 1 2 1,2 1 3 1,3 2 3 2,3

2 2 2 2 2 21 1 2 2 3 3 1 2 1,2 1 2 1 3 1,3 1 3 2 3 2,3 2 3

R w R w R w R

w w w 2w w Cov 2w w Cov 2w w Cov

w w w 2w w 2w w 2w w

= 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

uk l2 review course solutions 2013 v1-1.1

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