Sample CFA Level 2 question bank for June 2013 exam

[DG_Admin]

Team DG is glad to announce that Konvexity will provide free CFA Level 2 sample questions for the June, 2013 exam.


How it will work?

1. Existing users should login and subscribe to this thread. Some users may be automatically subscribed (depending on your profile settings) and can skip this step.

2. New users can Register and then login to subscribe to this thread. Click here to learn more.

3. When you go to the Subscription page, make sure to choose "Daily updates by email" option from the "Notification Type" dropdown. Then click "Add Subscription".

4. Konvexity will post a question and members can discuss the answer in this forum.


5. The solution and the next question will be posted on the following day.


All the best for your CFA Level 2 prep!

[Konvexity Institute]

Item Set for 13-March:

Robert Treacy Case Scenario

Robert Treacy is a high net worth individual. He is looking at the investment opportunity in a company Thermax Limited. He wants to acquire a majority stake in the company.

Thermax Limited is a small capitalization company operating in the energy sector. The income statement and balance sheet for the company for the recent year is given in Exhibit 1.

Exhibit 1
Income Statement (All figures are in millions of dollars)

	2013 Forecast	2012 Actual
Sales	400	350
COGS	220	200
SG&A	40	40
EBITDA	140	110
Depreciation	40	40
Amortization	15	15
EBIT	95	65
Interest Expense	27	25
Pre-tax Earnings	68	40
Taxes (at 40%)	27.2	16
Net Income	40.8	24

Balance Sheet

	2013 Forecast	2012 Actual
Cash	140	40
Accounts receivable	65	55
Inventory	80	75
Current Assets	285	170
Net PP&E	675	655
Patents	80	95
Total assets	1,040	920
Accounts payable	30	30
Notes payable	60	45
Current liabilities	90	75
Long-term debt	285	250
Shareholders' equity	550	500
Retained earnings	115	95
Total liabilities and owners' equity	1,040	920

Thermax Limited financial statements are according to U.S. GAAP. The company has not sold any asset during these two years. The financing data for the company has been provided in Exhibit 2.

Exhibit 2

Target D/E ratio	0.50
Marginal before-tax cost of debt	8.0%
Marginal cost of equity	12.0%
Marginal tax rate	40.0%

The free cash flow to the equity is expected to grow at a constant rate of 6% from 2013 onwards. The market value of debt is 110% of total book value of debt in 2012.

Robert Treacy is also valuing another company using free cash flow approach. He finds out that the company has issued debt at a discount to the par and is put up on the balance sheet at amortized cost. The amortized discount has been subtracted and the coupon payments have been added to the income statement. He is concerned about the treatment of these cash flows from the debt and their impact on the free cash flow to the firm.

The same company also has the deferred tax assets on its balance sheet. But those assets are expected to reverse in near future.


1. What is the free cash flow to the firm for Thermax Limited in 2013?
a) $22.0 milllion
b) $37.0 million
c) $77.0 million

2. What is the free cash flow to equity for Thermax Limited in 2013?
a) $32.0 million
b) $55.8 million
c) $70.8 million

3. What is the total net payment by the company to the equity holders in 2012?
a) -29.2 million
b) -44.2 million
c) -$68.0 million

4. What is the treatment of deferred tax assets on the free cash flow for the given company?
a) It should be subtracted from the net income to get FCFF
b) It should be added back to the net income to get FCFF
c) It should be ignored

5. What is the impact of the debt’s cash flows on the FCFF which is bought at a discount?
a) The amortized discount should be added back and the coupon payments should be subtracted from the net income to get FCFF
b) The amortized discount should be subtracted from the net income to get FCFF and the coupon payments should be ignored
c) The amortized discount should be added back to the net income to get FCFF and the coupon payments should be ignored

6. What is the market value of the firm for Thermax Limited in 2012?
a) $1,475.0 million
b) $1,504.5 million
c) $1,650.6 million

[Nidhi Taleja]

Thanks Konvexity Institute for taking this initiative. The question set is interesting and not very easy (which is good). Tried solving the first two questions using FCF = Operating cash flow - CapexAns for 1: BAns for 2: A

[mahesh]

Gr8 initiative. The questions are too good...

For 1, Free cash flow = NI + NCC –WCInv + Int*(1-t) – FCInv so, it should be A (-$18 milllion).

For 3, Total net payment by the company to the equity holders = net change in cash + Total net payment to equity holders. It should be C.


~Mahesh.

[Purav Gandhi]

(1) - a
(2) - b
(3) - c
(4) - a
(5) - c
(6) - b

[Prabir Bansal]

@Konvexity:- Nice Ques set. Do you have any training office for CFA in Bangalore location ??

Regards,
Prabir Bansal

[Konvexity Institute]

Solutions to Item Set for 13-March

1. Correct Answer is B: Free cash flow to the firm = NI + NCC –WCInv + Int*(1-t) – FCInv = 40.8 + (40+15) – {(65+80-30) – (55+75-30)} + 27*(1-0.4) – (675-655+40) = 40.8 + 55 – 15 + 16.2 – 60 = $37 million.
2. Correct Answer is C: Free cash flow to equity = FCFF – Int*(1-t) + Net borrowings = 37 – 27*(1-0.4) + (285+60 – 250-45) = 37 – 16.2 + 50 = $70.8 million
3. Correct Answer is A: FCFE = net change in cash + Total net payment to equity holders = 100 + Total net payment to equity holders. Net payment to equity holders = 70.8 – 100 = -$29.2 million.
4. Correct Answer is C: As the deferred tax assets are expected to reverse in the coming future, those assets should be ignored while calculating noncash charges.
5. Correct Answer is C: The amortized discount is a noncash item which was subtracted from the revenues to come at the net income. To get FCFF from net income, it should be added back again. The coupon payments should be ignored as those are the cash items.
6. Correct Answer is B: Required return on equity = 12.0%. Market value of equity = FCFE1/ (ke-g) = 70.8/ (0.12-0.06) = $1,180 million. Market value of debt = (250+45)*1.1 = $324.5 million. Market value of firm = 324.5 + 1,180 = $1,504.5 million.

[Konvexity Institute]

Item set for 14-March (Equity):

Ravi Kumar Adukia Case Scenario

Ravi Kumar Adukia is a fund manager for Adukia Investments. His fund was performing well before 2008 but after crisis hit in 2008, the fund has been not performing well. He analyzed the stocks and found out that they failed to take into account the sensitivity analysis in the valuations done by them. Because of that there were huge valuation errors in the valuations. The valuation got butchered by the rise in required rate of return and the fall in growth. Almost all of their valuations were based on the terminal value. The terminal value was very sensitive to the growth rate and the required rate of return.

He calls his best analyst, Rahul Daga, to discuss about this situation. He wants to change the models so that the effect of the sensitivity to the terminal value could be removed. Rahul Daga suggests the usage of residual income valuation model and states that in the residual income model, most of the value comes from the current book value and the terminal value is quite small.

He asks Rahul to change the models to residual income valuation models and to calculate the value of the stocks of the portfolio using that model. Rahul starts the valuation of a company using residual income valuation model. The data for the company has been provided in Exhibit 1.

Exhibit 1

Beginning book value of equity for 2012-13	$400 million
Ending book value of equity for 2012-13	$450 million
Required return on equity	12.0%
Persistence factor for residual earnings after 2013-14 (ω)	0.8
Earnings for 2012-13	$72 million
Outstanding common shares	1.2 million

The return of equity is expected to remain exactly the same in year 2013-14 as that of year 2012-13.

Ravi Kumar asks Rahul about the persistence factor and how does it impact the value of the stock in the relative valuation model.

Rahul: The ROE is not expected to remain forever higher than required return on equity. Eventually, it will come down and becomes equal in the long-run. When it becomes equal to the required return on equity, the residual income falls to zero. The persistence factor catches that fall. The higher is the persistence factor, the more is the economic profit earned by the firm because of the residual earnings.

Ravi Kumar: What are the major factors that impact the persistence factor?

Rahul: There are many factors like dividend payout ratio, persistence of residual income in the industry, the magnitude of ROE, and the accounting accruals.

Ravi Kumar: This model seems to be the perfect model for equity valuation. Are there any weaknesses of this model? Can it be used for every company?

Rahul: It is generally used to value banking sector stocks. However, it can be used for any company. The main limitations with regard to this model are the unreliability of accounting data and the violation of clean surplus equation.

Ravi Kumar: What are the driving factors of the stock price according to this model?

Rahul: The lower is the spread between ROE and required return on equity, the higher is the value of the equity.

Ravi Kumar: The formula of this model looks like that of justified P/B ratio. The justified P/B ratio is equal to (ROE – g)/(r-g) and the value of stock using this formula is (ROE-r)*B0/(r-g). The value of stock can also be written as (ROE-g)*B0/(r-g) – (r-g)*B0/(r-g) or (Justified (P/B) ratio – 1)*B0.

Rahul: Exactly. The higher is the value of justified P/B ratio, the higher is the value of the stock.




1. What is the value per share for the company?
a) $437.50
b) $445.31
c) $475.00

2. What is the present value of the company’s expected economic profit?
a) $75.00 million
b) $84.37 million
c) $112.25 million

3. What is the value of the company if the residual income persists forever?
a) $600 million
b) $650 million
c) $675 million

4. If the company has paid a dividend of $5 per share and its beginning book value per share was $25 per share and the earnings per share for the year were $7, what is the least likely value of the ending book value per share if there is a violation of clean surplus relation?
a) $23.00
b) $25.00
c) $27.00

5. Which of the following statements made by Rahul is least accurate?
a) About limitations of the residual income valuation model
b) About the driving factors of the price of the stock
c) About the persistence factor of the residual income

6. Which of the following factors is least likely to be associated with lower persistence factor?
a) High dividend payout ratios
b) Low magnitude of ROE
c) High accounting accruals

[rahuldaga89]

here is original Rahul Daga (not-so-best analyst ) . Though all the time I was confused but then I took 2012-13 year as year 0. and the answers are :

1) b - $ 445.31
2) b- 84.375 mn
3) c- 675 mn
4) c - $ 27
5) b - About the driving factors of the price of the stock
6) b - Low magnitude of ROE

[naveen]

here is original Rahul Daga (not-so-best analyst ) . Though all the time I was confused but then I took 2012-13 year as year 0. and the answers are :

1) b - $ 445.31
2) b- 84.375 mn
3) c- 675 mn
4) c - $ 27
5) b - About the driving factors of the price of the stock
6) b - Low magnitude of ROE

Great job Rahul...