CFA® Level II

Essay Examination Book

2000 Morning Section Candidate Number: _____ _____ _____ _____ _____ _____

THIS BOOK IS THE PROPERTY OF:

Association for Investment Management and Research Post Office Box 3668 Charlottesville VA 22903-0668 USA Tel: 804-951-5499

© 2000 Association for Investment Management and Research. All rights reserved.

FOR AIMR USE ONLY

FOR AIMR USE ONLY

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The following list contains the command words used on the Morning Section of the 2000 Level II examination. Candidates may want to refer to this list as they formulate their answers. calculate: To ascertain or determine by mathematical processes.

cite: To quote by way of evidence, authority, or proof.

compute: To determine, especially by mathematical means.

construct: To create by organizing ideas or concepts logically and coherently.

describe: To transmit a mental image, an impression, or an understanding of the nature

and characteristics of.

determine: To come to a decision as the result of investigation or reasoning; to settle or decide by choice among alternatives or possibilities.

discuss: To discourse about through reasoning or argument; to present in detail.

explain: To give the meaning or significance of; to provide an understanding of; to give the reason for or cause of.

identify: To establish the identity of; to show or prove the sameness of.

indicate: To point out or point to with more or less exactness; to show or make known with a fair degree of certainty.

justify: To prove or show to be valid, sound, or conforming to fact or reason; to furnish grounds or evidence for.

show: To set forth in a statement, account, or description; to make evident or clear.

state: To express in words.

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The Morning Section of the 2000 CFA Level II Examination has 21 questions. For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question.

Question Topic Minutes Item Set Exam Book

1-12 Ethical and Professional Standards 36 Essay Exam Book

13 Financial Statement Analysis 16 14 Financial Statement Analysis 14 15 Financial Statement Analysis 9 16 Portfolio Management 10 17 Quantitative Analysis 26 18 Asset Valuation 19 19 Asset Valuation 15 20 Asset Valuation 16 21 Asset Valuation 19 Total: 180

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QUESTION 13 HAS ONE PART FOR A TOTAL OF 16 MINUTES LifeCo, a large healthcare company, has agreed to acquire VitaCare, Inc. The acquisition will be paid for with stock using the pooling method of accounting. Proforma financial statements accounting for the acquisition are shown in the worksheet on page 4. Due to possible changes in merger accounting, Juan Hernandez, equity analyst, wants to analyze LifeCo if, alternatively, the purchase method is used to acquire VitaCare. Assume the following: • $2 billion purchase price is financed by issuing 50 million shares of LifeCo stock at $40. • Fair value of Vitacare’s property, plant, and equipment exceeds historical cost by $100

million. • All other VitaCare assets and liabilities are stated at fair market value. • VitaCare uses a 10-year useful life for all property, plant, and equipment, uses a 30-year

useful life for goodwill, uses straight-line depreciation and amortization, and assumes no salvage value.

Indicate the effect on LifeCo’s ratios in the template provided, assuming purchase accounting is used rather than pooling. Justify your choice of effect by referring to both the numerator and the denominator of each ratio. Note: No calculations are required; however, a worksheet is provided on page 4 to help you construct your answer. Answer Question 13 on the Template provided on page 5.

(16 minutes)

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This worksheet is provided to help candidates construct their answer to Question 13. Completion of the worksheet is not required and the worksheet will not be graded.

Pooling Purchase Proforma June 30, 2000 Balance Sheet ($ million) LifeCo VitaCare Method Adjustments Method Current Assets $9,000 $600 $9,600 Net Property & Equipment 7,000 800 7,800 Goodwill 550 50 600 Total Assets 16,550 1,450 18,000

Current Liabilities 3,000 250 3,250 Long-term debt 7,700 400 8,100 Total Liabilities 10,700 650 11,350

Stockholders Equity 5,850 800 6,650

Total Liabilities & Equity 16,550 1,450 18,000

Pooling Purchase Proforma Year 2000 Income Statement ($ million) LifeCo Vitacare Method Adjustments Method Revenue $12,300 $1,000 $13,300

Operating Costs 6,000 790 6,790 Depreciation 500 50 550 Operating Profit 5,800 160 5,960

SG&A Expense 3,250 26 3,276 Interest Expense 750 24 774

Income Before Taxes 1,800 110 1,910 Taxes 565 –20 545 Net Income 1,235 130 1,365

Earnings per share $2.11 $1.30 $2.15

Average shares outstanding (millions)

585 100 635

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Template for Question 13 LifeCo Ratio Effect

(Circle One) Justification

Debt/Equity

Higher

Lower

Unchanged

Asset Turnover

Higher

Lower

Unchanged

Pre-tax Margin

Higher

Lower

Unchanged

Return on Equity

Higher

Lower

Unchanged

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QUESTION 14 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES On December 31, 1999, LASI Construction entered into a major long-term construction contract with the following terms:

Total contract price: $3,000,000 Total expected cost: $2,400,000

Construction is expected to take three years. Production costs and cash flows are shown in Exhibit 14-1.

Exhibit 14-1 Production Costs and Cash Flows

Projected Year Costs Incurred Cash Received 2000 $900,000 $1,000,000 2001 $800,000 $1,000,000 2002 $700,000 $1,000,000 Total $2,400,000 $3,000,000

A. Show the revenue and pretax income for the indicated years under both the percentage-

of-completion method and the completed contract method.

Answer Question 14-A in the Template provided on page 9. (Note: The template should contain only the results of your calculations. Although space is provided below the template for calculations, calculations will not be graded.)

(8 minutes)

In addition to a difference in revenue and income recognition, other financial ratios and measures may also be affected by the accounting method chosen.

B. Indicate the effect on the following financial measures, in both fiscal years 2000 and

2002, of using the percentage-of-completion method rather than the completed contract method. • Return on Equity • Financial Leverage as measured by Assets/Equity • Operating Cash Flow

Answer Question 14-B in the Template provided on page 10.

(6 minutes)

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Template for Question 14-A (Do not provide answers for the blacked-out boxes.)

Percentage-of-Completion Method Completed Contract Method Year Revenue Pretax Income Revenue Pretax Income

2000

2001

2002

(The space below is provided for calculations, but calculations will not be graded.)

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Template for Question 14-B

Financial Measure Year 2000 Effect

(Circle One) Year 2002 Effect

(Circle One) Return on Equity

Higher

Lower

Unchanged

Higher

Lower

Unchanged

Financial Leverage (Assets/Equity)

Higher

Lower

Unchanged

Higher

Lower

Unchanged

Operating Cash Flow

Higher

Lower

Unchanged

Higher

Lower

Unchanged

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QUESTION 15 HAS ONE PART FOR A TOTAL OF 9 MINUTES A security analyst concludes that a company has increased reported earnings by changing assumptions in the company’s pension and postretirement health care plans. Indicate and explain the action required to increase reported earnings for each assumption shown on the template on page 13. Answer Question 15 in the Template provided on page 13.

(9 minutes)

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Template for Question 15

Assumption Action Required

(Circle One)

Explanation Estimate of the expected long-term return on plan assets.

Increase Return Estimate

Decrease Return Estimate

Estimate of the rate of compensation increase.

Increase Rate Estimate

Decrease Rate Estimate

Estimate of the future health care inflation rate.

Increase Inflation Rate Estimate

Decrease Inflation Rate Estimate

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QUESTION 16 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset pricing model for making recommendations to her clients. Her research department has developed the information shown in Exhibit 16-1.

Exhibit 16-1 Forecasted Returns, Standard Deviations, and Betas

Forecasted Return Standard Deviation Beta Stock X 14.0% 36% 0.8 Stock Y 17.0% 25% 1.5 Market Index 14.0% 15% 1.0 Risk Free Rate 5.0%

A. Calculate the following for each stock:

i. expected return ii. alpha

Answer Question 16-A in the Template provided on page 17.

(4 minutes)

B. Identify and justify which stock would be more appropriate for an investor who wants to

i. add this stock to a well-diversified equity portfolio. ii. hold this stock as a single-stock portfolio.

Answer Question 16-B in the Template provided on page 17.

(6 minutes)

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Template for Question 16-A Stock Expected Return Alpha

Stock X

Stock Y

Template for Question 16-B

Portfolio Identify Stock (Circle One)

Justification

Well-diversified equity portfolio

X

Y

Single-stock portfolio

X

Y

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QUESTION 17 HAS FOUR PARTS FOR A TOTAL OF 26 MINUTES Laura Hogan is investigating the ability of fundamental factor models to estimate the expected return of an equity portfolio. Using the data she has collected on her equity portfolio, she performs a regression analysis in an attempt to develop a fundamental factor model for her portfolio. Her data include quarterly observations of the fundamental variables. Her results are shown in Exhibits 17-1 and 17-2 below. Exhibits 17-3 and 17-4 contain critical t-statistics and F-statistics, respectively.

Exhibit 17-1 Fundamental Factor Model Regression Equation

RETURN = 8.59 – 0.44(P/E) + 3.52(P/B) – 1.73(Leverage) R-Squared 0.281 Standard Error 5.607 Observations 42 Sum of Square Regression (SSR) 470.73 Sum of Square Error (SSE) 1194.48 F-Statistic 4.99 Where: RETURN = quarterly total return on her portfolio in percent P/E = capitalization weighted price/earnings ratio of portfolio P/B = capitalization weighted price/book value ratio of portfolio Leverage = capitalization weighted assets/equity ratio of portfolio

Exhibit 17-2 Standard Deviations of Estimates

Intercept 6.91 P/E 0.13 P/B 0.94 Leverage 2.12

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Exhibit 17-3 Critical Values for Student’s t-Distribution

Area Under Tail Degrees of Freedom 2.50% 5.00%

30 2.36 2.04 31 2.36 2.04 32 2.35 2.04 33 2.35 2.03 34 2.35 2.03 35 2.34 2.03 36 2.34 2.03 37 2.34 2.03 38 2.33 2.02 39 2.33 2.02 40 2.33 2.02 41 2.33 2.02 42 2.32 2.02 43 2.32 2.02 44 2.32 2.02 45 2.32 2.01

Exhibit 17-4 Critical Values of F-Distribution at 5% Level of Significance

Degrees of Freedom for the Numerator Degrees of Freedom for the

Denominator 1 2 3 4 5 6 30 4.17 3.32 2.92 2.69 2.53 2.42 31 4.16 3.30 2.91 2.68 2.52 2.41 32 4.15 3.29 2.90 2.67 2.51 2.40 33 4.14 3.28 2.89 2.66 2.50 2.39 34 4.13 3.28 2.88 2.65 2.49 2.38 35 4.12 3.27 2.87 2.64 2.49 2.37 36 4.11 3.26 2.87 2.63 2.48 2.36 37 4.11 3.25 2.86 2.63 2.47 2.36 38 4.10 3.24 2.85 2.62 2.46 2.35 39 4.09 3.24 2.85 2.61 2.46 2.34 40 4.08 3.23 2.84 2.61 2.45 2.34 41 4.08 3.23 2.83 2.60 2.44 2.33 42 4.07 3.22 2.83 2.59 2.44 2.32 43 4.07 3.21 2.82 2.59 2.43 2.32 44 4.06 3.21 2.82 2.58 2.43 2.31 45 4.06 3.20 2.81 2.58 2.42 2.31

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A. Calculate the increase or decrease in the return Hogan could expect, based on changes in the following factors (treat each change in isolation):

i. Leverage increases by 1

ii. Price/Earnings ratio decreases by 3 iii. Price/Book Value ratio increases by 2

(6 minutes) B. i. State the extent to which the fundamental factor model regression explains the

return. Cite the appropriate test statistic. ii. Determine and explain whether all of the regression coefficients of the

independent variables are simultaneously equal to zero.

(8 minutes) C. State and justify whether the regression coefficient for the P/E ratio is statistically

different from zero at the 5 percent level of significance.

(6 minutes) Hogan is concerned with the potential existence of statistical problems. Consequently, she performs some additional analysis and creates the correlation matrix shown in Exhibit 17-5.

Exhibit 17-5 Fundamental Factor Model – Correlation Matrix

Variable P/E P/B Leverage P/E 1.00 P/B 0.82 1.00 Leverage 0.63 0.72 1.00

D. State and justify whether Exhibit 17-5 provides evidence that the following statistical

problems exist in Hogan’s fundamental regression:

i. autocorrelation ii. multicollinearity

(6 minutes)

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QUESTION 18 HAS THREE PARTS FOR A TOTAL OF 19 MINUTES A. Discuss how each of the following theories for the term structure of interest rates could

account for a downward sloping term structure of interest rates:

i. Pure Expectations ii. Liquidity Preference iii. Market Segmentation

(9 minutes)

The spot rates of interest for five U.S. Treasury Securities are shown in Exhibit 18-1. Assume all securities pay interest annually.

Exhibit 18-1 Spot Rates of Interest

Term to Maturity (years) Spot Rate of Interest 1 13.00% 2 12.00% 3 11.00% 4 10.00% 5 9.00%

B. i. Compute the two-year implied forward rate three years from now.

ii. Explain your answer using the Pure Expectations theory.

(6 minutes) C. Compute the price of a five-year annual-pay Treasury security with a coupon rate of 9

percent, using the information in Exhibit 18-1.

(4 minutes)

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QUESTION 19 HAS TWO PARTS FOR A TOTAL OF 15 MINUTES Martin Bowman is preparing a report distinguishing traditional debt securities from structured note securities. A. Discuss how the following structured note securities differ from a traditional debt

security with respect to coupon and principal payments:

i. Equity Index-Linked Notes ii. Commodity-Linked Bear Bond

(6 minutes)

Bowman is also analyzing a dual currency bond (USD/CHF) as a possible addition to his bond portfolio. Bowman is a USD-based investor and believes the CHF will appreciate against the USD over the life of the bond.

B. i. Describe the principal and coupon components of a dual currency bond.

ii. State one reason why a dual currency bond might trade at a premium over an otherwise identical single currency bond.

iii. Discuss whether there is an impact on a dual currency bond’s interest payments

and principal payments if the CHF appreciates against the USD over the life of the bond.

(9 minutes)

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QUESTION 20 HAS THREE PARTS FOR A TOTAL OF 16 MINUTES Acree Corporation issued a floating rate note that pays 1-year LIBOR+1 percent annually. The note has a par value of $100 million and a remaining term of five years. A. Describe the interest rate risk that Acree faces.

(4 minutes) John Whalen, Acree’s Chief Financial Officer, is considering entering a five-year interest rate swap.

B. Describe how each of the following strategies would be structured, and explain how

each strategy can eliminate Acree’s interest rate risk: i. a plain vanilla interest rate swap ii. a portfolio of Eurodollar futures contracts

(8 minutes)

Whalen is entering into a five-year swap, and would like the right to cancel the swap after three years if interest rates decline. C. Identify the appropriate instrument that Whalen could purchase and explain how Whalen

can use the instrument to achieve his objective.

(4 minutes)

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QUESTION 21 HAS THREE PARTS FOR A TOTAL OF 19 MINUTES A stock index is currently trading at 50.00. The annual index standard deviation is 20 percent. Paul Tripp, CFA, wants to value two-year index options using the binomial model. To correctly value the options, he needs the formulas in Exhibit 21-1. The annual risk-free interest rate is 6 percent. Assume no dividends are paid on any of the underlying securities in the index.

Exhibit 21-1 Formulas for Option Valuation

teU ∆= σ

where

1.2214=U

UD

1= DU

De tr

u −−=

∆

π

where e r∆t = 1.06184

Where: U = up movement factor D = down movement factor πu = probability of an upward price movement

Exhibit 21-2 Discount Factors

5.00% 6.00% 7.00%

PERIOD 1 0.95123 0.94176 0.93239

PERIOD 2 0.90484 0.88692 0.86936

PERIOD 3 0.86071 0.83527 0.81058

A. Construct a two-period binomial lattice for the stock index.

(6 minutes)

B. Calculate the value of a European index call option with an exercise price of 60.00.

(10 minutes) C. Calculate the value of a European index put option with an exercise price of 60.00.

(3 minutes)

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CFA Level II Examination 2000 Morning Section

IMPORTANT INSTRUCTIONS TO CANDIDATES 1. Write your candidate number in the spaces provided at the top left corner of the front cover

of this Essay Exam book and of the Item Set Exam book. 2. Instructions for using the Item Set Exam answer sheet (computer scan sheet):

• Use a No. 2 or HB pencil to record your answers on the answer sheet. • Read and sign the pledge at the bottom of your answer sheet. Write your exam center

code and today’s date on the lines provided in the pledge section. • Write your name in the spaces provided at the top of the answer sheet. Darken the ovals

that correspond with the letters in your name. • Write your candidate number in the spaces provided at the top of your answer sheet.

Darken the ovals that correspond to your candidate number. • Select the best answer for each question and darken the oval that corresponds with your

answer. Only answers recorded on the answer sheet will be graded. Any marks you make in the exam book will not be graded.

• Do not make any stray marks on the answer sheet.

3. Instructions for using the Essay Exam answer pages: • Write your answers in blue or black ink on the correct answer pages in the Essay Exam

book. • Label each part of your answer (A, B, C, or i, ii, iii, etc.). • Only answers written on the correct answer pages will be graded. You may make marks

and notes on the question pages, but these marks will not be graded. • If you use all of the designated answer pages, check the box at the bottom of the last page

of your answer and continue your answer on the unnumbered extra pages at the back of the exam book. Label extra pages with the correct question number.

DO NOT OPEN THIS EXAM BOOK UNTIL INSTRUCTED TO DO SO BY THE PROCTOR.

DO NOT REMOVE ANY EXAM BOOK OR ANSWER SHEET FROM THE EXAM ROOM.

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CFA® Level II

Essay Examination Book

2000 Afternoon Section Candidate Number: _____ _____ _____ _____ _____ _____

THIS BOOK IS THE PROPERTY OF:

Association for Investment Management and Research Post Office Box 3668 Charlottesville VA 22903-0668 USA Tel: 804-951-5499

© 2000 Association for Investment Management and Research. All rights reserved.

FOR AIMR USE ONLY

FOR AIMR USE ONLY

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The following list contains the command words used on the Afternoon Section of the 2000 Level II examination. Candidates may want to refer to this list as they formulate their answers. calculate: To ascertain or determine by mathematical processes.

compute: To determine, especially by mathematical means.

contrast: To compare in respect to differences.

critique: To offer a critical review or commentary; to criticize.

describe: To transmit a mental image, an impression, or an understanding of the nature

and characteristics of.

discuss: To discourse about through reasoning or argument; to present in detail.

explain: To give the meaning or significance of; to provide an understanding of; to give the reason for or cause of.

give: To yield or furnish as a product, consequence, or effect; to offer for the consideration, acceptance, or use of another.

identify: To establish the identity of; to show or prove the sameness of.

indicate: To point out or point to with more or less exactness; to show or make known with a fair degree of certainty.

justify: To prove or show to be valid, sound, or conforming to fact or reason; to furnish grounds or evidence for.

show: To set forth in a statement, account, or description; to make evident or clear.

state: To express in words.

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The Afternoon Section of the 2000 CFA Level II Examination has 12 questions. For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question.

Question Topic Minutes 22 Asset Valuation 21 23 Asset Valuation 8 24 Asset Valuation 20 25 Asset Valuation 12 26 Asset Valuation 12 27 Financial Statement Analysis 23 28 Financial Statement Analysis 18 29 Financial Statement Analysis 6 30 Portfolio Management 12 31 Economics 20 32 Asset Valuation 15 33 Asset Valuation 13 Total: 180

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Questions 22 through 29 relate to Telluride and its subsidiaries. A total of 120 minutes is allocated to these questions. Review the Introduction below, and Exhibits 22-1 and 22-2 on page 3. Candidates should answer these questions in the order presented.

INTRODUCTION The management of Telluride, an international diversified conglomerate based in the United States, believes that the recent strong performance of its wholly owned medical supply subsidiary, Sundanci, has gone unnoticed. In order to realize Sundanci’s full value, Telluride has announced that it will divest Sundanci in a tax-free spinoff. Sue Carroll, CFA, is the Director of Research at Kesson and Associates. In developing an investment recommendation for Sundanci, Carroll has directed four of her analysts to determine a valuation of Sundanci using various valuation disciplines. To assist her analysts, Carroll has gathered the information shown in Exhibits 22-1 and 22-2 on page 3.

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Exhibit 22-1

Sundanci Actual 1999 and 2000 Financial Statements For Fiscal Years Ending May 31 ($ million, except per-share data)

Income Statement 1999 2000 Revenue $474 $598 Depreciation 20 23 Other operating costs 368 460 Income before taxes 86 115 Taxes 26 35 Net income 60 80 Dividends 18 24 Earnings per share $0.714 $0.952 Dividend per share $0.214 $0.286 Common shares outstanding (millions) 84.0 84.0 Balance Sheet 1999 2000 Current assets $201 $326 Net property, plant and equipment 474 489 Total Assets 675 815 Current liabilities 57 141 Long-term debt 0 0 Total Liabilities 57 141 Shareholders Equity 618 674 Total liabilities and equity 675 815 Capital expenditures 34 38

Exhibit 22-2 Selected Financial Information

Required Rate of Return on Equity 14% Growth Rate of Industry 13% Industry P/E Ratio 26

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QUESTION 22 HAS TWO PARTS FOR A TOTAL OF 21 MINUTES Prior to determining Sundanci’s valuation, Carroll analyzes Sundanci’s return on equity (ROE) and sustainable growth. A. i. Calculate the three components of ROE in the duPont formula for the year 2000. ii. Calculate ROE for the year 2000. iii. Calculate the sustainable rate of growth. Show your work.

(12 minutes)

Carroll learns that Sundanci’s Board of Directors is considering the following policy changes that will affect Sundanci’s sustainable growth rate: • Director A proposes an increase in the quarterly dividend to $0.15 per share. • Director B proposes a bond issue of $25 million, the proceeds of which would be used to

increase production capacity. • Director C proposes a 2-for-1 stock split. B. Indicate the effect of each of these proposals on Sundanci’s sustainable rate of growth,

given that other factors remain unchanged. Identify which component of the sustainable growth model, if any, is directly affected by each proposal.

Answer Question 22-B using the Template on page 8.

(9 minutes)

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Template for Question 22-B

Proposal Effect on Sustainable

Growth Rate (Circle One)

Component Directly Affected (If Any)

Increase in quarterly dividend

Increase

Decrease

No Effect

Bond issue

Increase

Decrease

No Effect

Stock split

Increase

Decrease

No Effect

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QUESTION 23 HAS ONE PART FOR A TOTAL OF 8 MINUTES Helen Morgan, CFA, has been asked by Carroll to determine the potential valuation for Sundanci, Inc. using the dividend discount model (DDM). Morgan anticipates that Sundanci’s earnings and dividends will grow at 32% for two years and 13% thereafter. Calculate the current value of a share of Sundanci stock using a two-stage dividend discount model and the data from Exhibits 22-1 and 22-2 on page 3. Show your work.

(8 minutes)

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QUESTION 24 HAS THREE PARTS FOR A TOTAL OF 20 MINUTES Abbey Naylor, CFA, has been directed by Carroll to determine the value of Sundanci’s stock using the Free Cash Flow to Equity (FCFE) model. Naylor believes that Sundanci’s FCFE will grow at 27% for two years and 13% thereafter. Capital expenditures, depreciation, and working capital are all expected to increase proportionately with FCFE. A. Calculate the amount of FCFE per share for the year 2000, using the data from Exhibit

22-1 on page 3. Show your work.

(6 minutes) B. Calculate the current value of a share of Sundanci stock based on the two-stage FCFE

model. Show your work.

(8 minutes) C. i. Describe one limitation of the two-stage DDM model that is addressed by using

the two-stage FCFE model.

ii. Describe one limitation of the two-stage DDM model that is not addressed by using the two-stage FCFE model.

(6 minutes)

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QUESTION 25 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES Christie Johnson, CFA, has been assigned by Carroll to analyze Sundanci using the constant dividend growth price/earnings (P/E) ratio model. Johnson assumes that Sundanci’s earnings and dividends will grow at a constant rate of 13%. A. Calculate the P/E ratio based on information in Exhibits 22-1 and 22-2 on page 3 and on

Johnson’s assumptions for Sundanci. Show your work.

(4 minutes) B. Identify, within the context of the constant dividend growth model, how each of the

fundamental factors shown in the Template on page 22 would affect the P/E ratio.

Note: A change in a fundamental factor is assumed to happen in isolation and interactive effects between factors are ignored. Every other element of the firm is unchanged. Answer Question 25-B in the Template provided on page 22.

(4 minutes)

C. Explain why an increase in the dividend payout ratio may not have the effect that the

constant dividend growth P/E ratio model suggests.

(4 minutes)

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Answer Template for 25-B Fundamental Factor Effect on P/E Ratio

(Circle One) The riskiness (beta) of Sundanci increases substantially.

Increase

Decrease

May Increase or Decrease

The estimated growth rate of Sundanci’s earnings and dividends increases.

Increase

Decrease

May Increase or Decrease

The dividend payout ratio of Sundanci increases.

Increase

Decrease

May Increase or Decrease

The market risk premium increases.

Increase

Decrease

May Increase or Decrease

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QUESTION 26 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES One week after the spinoff of Sundanci, Carroll asks analyst Jim Martin to use Economic Value Added (EVA®) and Market Value Added (MVA) to measure the performance of Sundanci. In addition to the information provided in Exhibits 22-1 and 22-2 on page 3, Martin uses the following information in his analysis: • Adjusted net operating profit after tax (NOPAT) is $100 million. • Total adjusted capital is $700 million. • Closing stock price is $26. A. Calculate the following for Sundanci. Show your work.

i. EVA for fiscal 2000 ii. MVA as of fiscal year-end 2000

(6 minutes)

B. Discuss the two primary differences in calculating economic profit (as used in EVA)

versus accounting profit.

(6 minutes)

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QUESTION 27 HAS THREE PARTS FOR A TOTAL OF 23 MINUTES Telluride has a wholly owned foreign subsidiary, Fuente, Ltd., whose functional currency is the local currency (LC). The relevant exchange rates for Fuente are shown below.

Exhibit 27-1 Exchange Rates

Date LC/US$ At purchase of Fixed Assets (historic rate) 1.10 January 1, 1999 1.03 Average for 1999 0.95 December 31, 1999 0.87

A. Calculate the reporting currency (US$) amounts, using the appropriate translation

method, for the balance sheet and income statement accounts indicated by the blank boxes in the template on page 33.

Answer Question 27-A in the Template provided on page 33.

(5 minutes)

B. Indicate, based on the all-current method, whether the four ratios in the template are the

same or different in the reporting currency compared to the local currency. No calculations are necessary.

Answer Question 27-B in the Template provided on page 34.

(8 minutes)

C. Indicate whether the five ratios in the template are the same or different under the

temporal method compared to the all-current method. No calculations are necessary.

Answer Question 27-C in the Template provided on page 34.

(10 minutes)

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Template for Question 27-A (Do not provide answers for the blacked-out boxes.)

BALANCE SHEET as of December 31, 1999 LC US$ Cash 15.2 Accounts Receivable

3.8

Inventories 7.7 Fixed Assets (Net)

35.6

Other 12.1 Total Assets 74.4 Current Liabilities 13.3 Long Term Debt

19.6

Total Liabilities 32.9 Stockholders’ Equity 41.5 Total Liabilities and Equity 74.4

INCOME STATEMENT for the Year Ended December 31, 1999 LC US$ Revenue

47.1

Cost of Goods Sold 16.9 Depreciation 3.2 Other Operating Costs 14.8 Operating Profit 12.2 Interest Expense

3.4

Income Before Taxes 8.8 Taxes 3.2 Net Income 5.6

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Template for Question 27-B Ratio

Ratio Same or Different in Reporting Currency vs. Local Currency

(Circle One) Return on Assets

Same

Different

Debt/Assets

Same

Different

Net Profit Margin

Same

Different

Accounts Receivable Turnover

Same

Different

Template for Question 27-C

Ratio

Ratio Same or Different under Temporal Method vs. All-Current Method

(Circle One) Return on Assets

Same

Different

Debt/Assets

Same

Different

Net Profit Margin

Same

Different

Accounts Receivable Turnover

Same

Different

Quick

Same

Different

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QUESTION 28 HAS ONE PART FOR A TOTAL OF 18 MINUTES Patricia Bouvier, CFA is an analyst following Telluride. In reviewing Telluride’s 1999 annual report, Bouvier discovers the following footnotes: Footnote (1) During the fourth quarter of 1999, Telluride changed its accounting policy from

expensing to capitalizing software expenditures. The amount capitalized in 1999 was $15 million, including $12 million that had been expensed during the first three quarters of the year.

Footnote (2) On December 31, 1999, Telluride established a restructuring charge of $20

million, of which $8 million was for severance pay for workers who will be terminated in the year 2000 and $12 million was for the write down of assets on December 31, 1999.

Footnote (3) Telluride leases assets under an operating lease that expired on December 31,

1999. The lease renewal terms required Telluride to capitalize the lease, which has a present value of $50 million. The amount of the monthly lease payment does not change.

Indicate, for each of the three footnotes, the effect of the adjustments on the financial ratios shown in the template on pages 37 and 38 for: i. the year 1999. ii. the year 2000 compared to adjusted 1999.

Note: Assume all financial information remains unchanged from 1999 through 2000, except that referenced in the footnotes above. Answer Question 28 using the Template provided on pages 37 and 38.

(18 minutes)

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Template for Question 28 Ratio

Effect on 1999 Ratio (Circle One)

Effect on 2000 Ratio Compared to Adjusted 1999 Ratio (Circle One)

Footnote (1) Operating Cash Flow / Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Net Income / Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Sales / Net Fixed Assets

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Footnote (2) Operating Cash Flow / Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Net Income / Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Sales / Net Fixed Assets

Increase

Decrease

No Effect

Increase

Decrease

No Effect

(Template continued on next page)

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Template for Question 28 (continued) Footnote (3) Operating Cash Flow / Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Net Income / Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Sales / Net Fixed Assets

Increase

Decrease

No Effect

Increase

Decrease

No Effect

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QUESTION 29 HAS ONE PART FOR A TOTAL OF 6 MINUTES On January 1, 1998 Telluride purchased a 10% equity interest in Cervante, Ltd., a privately held Italian shoemaker. On January 1, 2000 Telluride purchased an additional 25% equity interest in Cervante. Exhibit 29-1 shows Cervante’s net income (loss) and dividends for 1998–2000.

Exhibit 29-1 Cervante’s Net Income (Loss) and Dividends

For the Year Ended December 31 Net Income (Loss) Dividends Paid

1998 $1,000,000 $300,000

1999 ($2,000,000) $400,000

2000 estimate $2,500,000 $500,000

Calculate the effect of the investments on Telluride’s pretax income for 1998, 1999, and 2000. Show your work.

(6 minutes)

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QUESTION 30 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES Dudley Trudy, CFA recently met with one of his clients. Trudy typically invests in a master list of thirty equities drawn from several industries. As the meeting concluded, the client made the following statement: “I trust your stock-picking ability and believe that you should invest my funds in your five best ideas. Why invest in thirty companies when you obviously have stronger opinions on a few of them?” Trudy plans to respond to his client within the context of Modern Portfolio Theory. A. Contrast the concepts of systematic risk and firm-specific risk, and give one example of

each risk.

(6 minutes) B. Critique the client’s suggestion. Discuss the impact of the following on portfolio risk as

the number of securities in a portfolio is increased:

i. systematic risk ii. firm-specific risk

(6 minutes)

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QUESTION 31 HAS TWO PARTS FOR A TOTAL OF 20 MINUTES Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African Rands (ZAR). Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the ZAR will appreciate relative to the CHF during this 30-day period. Exhibit 31-1 shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD).

Exhibit 31-1 Currency Exchange Rates

ZAR / USD CHF / USD Maturity Bid Ask Bid Ask

Spot 6.2681 6.2789 1.5282 1.5343 30-day 6.2538 6.2641 1.5226 1.5285 90-day 6.2104 6.2200 1.5058 1.5115

A. i. Describe the currency transaction that Omni should undertake to eliminate

currency risk over the 30-day period. ii. Calculate the following:

• The CHF / ZAR cross currency rate Omni would use in valuing the Swiss

equity portfolio. • The current value of Omni’s Swiss equity portfolio in ZAR. • The annualized forward premium or discount at which the ZAR is trading

versus the CHF.

(11 minutes)

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One year later Omni gathers the financial information in Exhibit 31-2:

Exhibit 31-2 Financial Information

Base price level 100 Current US price level 105 Current South African price level 115 Base Rand spot exchange rate $0.175 Current Rand spot exchange rate $0.158 Expected annual US inflation 7% Expected annual South African inflation 5% Expected US one-year interest rate 10% Expected South African one-year interest rate 8%

Omni uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. B. Calculate the following exchange rates:

i. The current ZAR spot rate in USD that would have been forecast by PPP.

ii. Using the IFE, the expected ZAR spot rate in USD one year from now.

iii. Using PPP, the expected ZAR spot rate in USD four years from now.

(9 minutes)

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QUESTION 32 HAS THREE PARTS FOR A TOTAL OF 15 MINUTES Joan Tam, CFA, believes she has identified an arbitrage opportunity for a commodity as indicated by the information given in Exhibit 32-1.

Exhibit 32-1 Commodity Price and Interest Rate Information

Spot price for commodity $120 Futures price for commodity expiring in 1 year $125 Interest rate for one year 8%

A. Describe the transactions necessary to take advantage of this specific arbitrage

opportunity.

(6 minutes) B. Calculate the arbitrage profit.

(3 minutes)

C. Describe two market imperfections that could limit Tam’s ability to implement this

arbitrage strategy.

(6 minutes)

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QUESTION 33 HAS TWO PARTS FOR A TOTAL OF 13 MINUTES Exhibits 33-1 and 33-2 contain information on three newly issued AAA-rated bonds.

Exhibit 33-1

Bond Characteristics Bond A Bond B Bond C

Coupon 7.00% 7.00% 7.00% Maturity June 3, 2005 June 3, 2005 June 3, 2005

Modified Duration 4.15 4.17 4.16 Standard Convexity 0.21 0.21 0.21

Exhibit 33-2 Effective Duration and Effective Convexity for Various Shifts in the Term Structure

Bond A Bond B Bond C Term Structure Shift (basis points)

Effective Duration

Effective Convexity

Effective Duration

Effective Convexity

Effective Duration

Effective Convexity

–500 0.49 0.47 4.35 22.65 4.34 22.51 –300 0.49 0.47 4.28 22.04 4.27 21.86 –100 0.48 0.48 4.20 21.56 4.18 21.18 +100 4.11 20.57 0.48 0.47 4.12 20.66 +300 4.04 19.98 0.48 0.44 4.05 20.03 +500 3.97 19.35 0.47 0.44 3.98 19.45

A. State and justify which of the three bonds is:

i. putable ii. callable iii. option-free

The justification for each should include discussion of the extent to which price compression and truncation are relevant.

(9 minutes) B. Compute the percentage price change for Bond A for an increase in yield of 50 basis

points immediately following a 300 basis point downward shift in the term structure.

(4 minutes)

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CFA Level II Examination 2000 Afternoon Section

IMPORTANT INSTRUCTIONS TO CANDIDATES 1. Write your candidate number in the spaces provided at the top left corner of the front cover

of this exam book. 2. Write your answers in blue or black ink on the correct answer pages in the exam book. 3. Label each part of your answer (A, B, C, or i, ii, iii, etc.). 4. Only answers written on the correct answer pages will be graded. You may make marks and

notes on the question pages, but these marks will not be graded. 5. If you use all of the designated answer pages, check the box at the bottom of the last page of

your answer and continue your answer on the unnumbered extra pages at the back of the exam book. Label extra pages with the correct question number.

DO NOT OPEN THIS EXAM BOOK UNTIL INSTRUCTED TO DO SO BY THE PROCTOR.

DO NOT REMOVE THIS EXAM BOOK FROM THE EXAM ROOM.

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