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CFA Institute CFA Level II Chartered Financial Analyst Exam

Certification Provider: CFA Institute
Exam Name: CFA Level II Chartered Financial Analyst
Duration: 180 Minutes
Number of questions in our database: 715
Exam Version: Jan. 20, 2023
Exam Official Topics:
  • Topic 1: Equity Valuation
  • Topic 2: Financial Reporting and Analysis
  • Topic 3: Ethical and Professional Standards .

Free CFA Institute CFA Level II Chartered Financial Analyst Exam Actual Questions

The questions for CFA Level II Chartered Financial Analyst were last updated On Jan. 20, 2023

Question #1

Lauren Jacobs, CFA, is an equity analyst for DF Investments. She is evaluating Iron Parts Inc. Iron Parts is a manufacturer of interior systems and components for automobiles. The company is the world's second largest original equipment auto parts supplier, with a market capitalization of $1.8 billion. Based on Iron Parts's low price-to-book value ratio of 0.9* and low price-to-sales ratio of 0.15x, Jacobs believes the stock could be an interesting investment. However, she wants to review the disclosures found in the company's financial footnotes. In particular, Jacobs is concerned about Iron Parts's defined benefit pension plan. The following information for 2007 and 2008 is provided.

Iron Parts has adopted SFAS No. 158, Employers' Accounting for Defined Benefit Pensions and Other Postretirement Plans.

Jacobs wants to fully understand the impact of changing pension assumptions on Iron Parts's balance sheet and income statement. In addition, she would like to compute Iron Parts's economic pension expense.

As of December 31, 2008, the funded status of Iron Parts's pension plan was:

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Correct Answer: B

Funded status equals fair value of plan assets minus PBO (395 - 635 = -240). (Study Session 6, LOS 22.c,f)


Question #2

Rock Torrey, an analyst for International Retailers Incorporated (IRI), has been asked to evaluate the firm's swap transactions in general, as well as a 2-year fixed for fixed currency swap involving the U .S . dollar and the Mexican peso in particular. The dollar is Torrey's domestic currency, and the exchange rate as of June 1,2009, was $0.0893 per peso. The swap calls for annual payments and exchange of notional principal at the beginning and end of the swap term and has a notional principal of $100 million. The counterparty to the swap is GHS Bank, a large full-service bank in Mexico.

The current term structure of interest rates for both countries is given in the following table:

Torrey believes the swap will help his firm effectively mitigate its foreign currency exposure in Mexico, which sterns mainly from shopping centers in high-end resorts located along the eastern coastline. Having made this conclusion, Torrey begins writing his report for the management of IRI. In addition to the terms of the swap, Torrey includes the following information in the report:

* Implicit in the currency swap under consideration is a swap spread of 75 basis points over 2-year U .S . Treasury securities. This represents a 10 basis point narrowing of the spread as compared to this time last year. Thus, we can assume that the credit risk of the global credit market has decreased. Unfortunately, the decline provides no insight into the credit risk of the individual currency swap with GHS Bank, which could have increased.

* In order to decrease the counterparty default risk on the currency swap, we will need to utilize credit derivatives between the beginning and midpoint of the swap's life when this particular risk is at its highest. This is a significantly different strategy than we normally use with interest rate swaps. For interest rate swaps, counterparty default risk peaks at the middle of the swap's life, at which point we utilize credit derivative CQuntermeasures to offset the risk.

* Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from IRI.

Six months have passed (180 days) since Torrey issued his report to IRI's management team, and the current exchange rate is now $0,085 per peso. The new term structure of interest rates is as follows:

Evaluate Torrey's statements regarding IRPs ability to mitigate the credit risk inherent in currency swaps and interest rate swaps. Torrey is only correct regarding:

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Correct Answer: B

Torrey is only correct regarding mark-to-market agreements. Using mark-to-marker agreements for interest rate swaps will reduce credit risk by periodically computing the value of the swap and then requiring payment of that amount by one of the counterparties. At some predetermined time, the swap is revalued according to the new term structure of interest rates, and one party pays the other party any amount due. The swap is then repriced, essentially creating a new swap with no credit risk. Netting payments is also an effective way to reduce credit risk in interest rate and equity swaps. However, currency swap payments are generally not netted. Torrey has incorrectly stated that netting is almost always used in currency swaps. Using off-market swaps is not generally a method to reduce credit risk. If IRI enters into an off-market swap in which they do not owe a payment, then a payment is owed to IRI by the counterparty. This would actually increase credit risk since the counterparty could potentially default on the initial payment. (Study Session 17,'LOS 61A)


Question #3

GigaTech Inc. is a large U .S .-based technology conglomerate. The firm has business units in three primary categories: hardware manufacturing, software development, and consulting services. Because of the rapid pace of technological innovation, GigaTech must make capital investments every two to four years. The company has identified several potential investment opportunities for its hardware manufacturing division. The first of these opportunities, Tera Project, would replace a portion of GigaTech's microprocessor assembly equipment with new machinery expected to last three years. The current machinery has a book value of $120,000 and a market value of $195,000. Tcra Project would require purchasing machinery for $332,000, increasing current assets by 5190,000, and increasing current liabilities by $80,000. GigaTech has a tax rate of 40%. Additional pro forma information related to the Tera Project is provided in the following table:

Analysts at GigaTech have noted that investment in the Tera Project can be delayed for up to nine months if managers at the company decide this is necessary. However, once the capital investment is made, the project will be necessary to maintain continuing operations. Tera Project can be scaled up with more equipment requiring less capital than the original investment if results are meeting expectations. In addition, the equipment used in Tera Project can be used in shift work if brief excess demand is expected.

GigaTech is also considering expanding its software development operations in India. Software development equipment must be continually replaced to maintain efficiency as newer and faster technology is developed. The company has identified two mutually exclusive potential expansion projects, Zeta and Sigma. Zeta requires investing in equipment with a 3-year life, while Sigma requires investing in equipment with a 2-year life. GigaTech has estimated real capital costs for the two projects at 10.58%. GigaTech expects inflation to be approximately 4.0% for the foreseeable future. Nominal cash flows and net present values for the Zeta and Sigma projects are provided in the following table:

Recently, GigaTechs board of directors has become concerned with the firm's capital budgeting decisions and has asked management to provide a detailed explanation of the capital budgeting process. After reviewing the report from management, the board makes the following comments in a memo:

* The capital rationing system being utilized is fundamentally flawed since, in some instances, projects that do not increase earnings per share are selected over projects that do increase earnings per share.

* The cash flow projections are flawed since they fail to include costs incurred in the search for projects or the economic consequences of increased competition resulting from highly profitable projects.

* We are making inappropriate investment decisions since the discount rate used to evaluate all potential projects is the firm's weighted average cost of capital.

Which of the following would best correct GigaTech's discount rate problem described in the board of director's memo?

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Correct Answer: B

When evaluating pocential capital investment projects, the discount rate should be adjusted for the risk of the project under consideration. This is frequently accomplished by determining a project beta and using this beta in the CAPM security market line equation: + [E( ) - ]. Project betas can be determined in a number of ways including using proxy firms with operations similar to the project under consideration, estimating an accounting beta, or through cross-sectional regression analysis. Whatever method used to determine the discount rate, it should be clear that the weighted average cost of capital (WACC) is only appropriate for projects with risk similar to the overall firm. If a project is more (less) risky than the overall firm, the discount rate used to evaluate the project should be greater (less) than rhe firm's WACC. (Study Session 8, LOS 27-e)


Question #4

Fashion Inc. is a major U .S . distributor of high quality women's jewelry and accessories. The company's growth in recent years has been moderately above the industry average. However, competition is intensifying as a number of overseas competitors have entered this mature market. Although Fashion has been a publicly held company for many years, members of senior management and their families control 20% of the outstanding common stock. Martin Silver, the Chief Executive Officer, has been under intense pressure from both internal and external large shareholders to find ways to increase the company's future growth.

Silver has consulted with the company's investment bankers concerning possible merger targets. The most promising merger target is Flavoring International, a distributor of a broad line of gourmet spices in the United States and numerous other countries. In recent years, Flavoring's earnings growth rate has been above competitors' and also has exceeded Fashion's experience. Superior income growth is projected to continue over at least the next five years. Silver is impressed with the appeal of the company's products to upscale customers, its strong operating and financial performance, and Flavoring's dynamic management team. He is contemplating retirement in three years and believes that Flavoring's younger, more aggressive senior managers could boost the combined company's growth through increasing Fashion's operating efficiency and expanding Fashion's product line in countries outside the United States. Alan Smith, who is Silver's key contact at the investment banking firm, indicates that a key appeal of this merger to Flavoring would be Fashion's greater financial flexibility and access to lower cost sources of financing for expansion of its products in new geographic areas. Fashion has a very attractive performance based stock option plan. Flavoring's incentive plan is entirely based on cash compensation for achieving performance goals. Additionally, the 80% of Fashion's stock not controlled by management interests is very widely held and trades actively. Flavoring became a publicly held company three years ago and doesn't trade as actively.

Silver has asked Smith to prepare a report summarizing key points favoring the acquisition and an acceptable acquisition price. In preparing his report, Smith relics on the following financial data on Fashion, Flavoring, and four recently acquired food and beverage companies.

The strongest motivations for Fashion to acquire Flavoring would most likely be:

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Correct Answer: C

Management incentives are a key factor in light of Mr. Silvers desire to retire in three years and his interest in Flavoring management's capabilities to help guide the combined firm. Diversification is another key motivation as Flavoring's products are consumer based but serve a different market than Fashions focus on consumer accessories. Because the companies have different product lines, synergies in the form of cost savings or revenue enhancement are unlikely to occur. In addition, the companies are in very different industries making increased market power in either industry unlikely to occur as a result of the merger. (Study Session 9, LOS 31.b,d)


Question #5

Fashion Inc. is a major U .S . distributor of high quality women's jewelry and accessories. The company's growth in recent years has been moderately above the industry average. However, competition is intensifying as a number of overseas competitors have entered this mature market. Although Fashion has been a publicly held company for many years, members of senior management and their families control 20% of the outstanding common stock. Martin Silver, the Chief Executive Officer, has been under intense pressure from both internal and external large shareholders to find ways to increase the company's future growth.

Silver has consulted with the company's investment bankers concerning possible merger targets. The most promising merger target is Flavoring International, a distributor of a broad line of gourmet spices in the United States and numerous other countries. In recent years, Flavoring's earnings growth rate has been above competitors' and also has exceeded Fashion's experience. Superior income growth is projected to continue over at least the next five years. Silver is impressed with the appeal of the company's products to upscale customers, its strong operating and financial performance, and Flavoring's dynamic management team. He is contemplating retirement in three years and believes that Flavoring's younger, more aggressive senior managers could boost the combined company's growth through increasing Fashion's operating efficiency and expanding Fashion's product line in countries outside the United States. Alan Smith, who is Silver's key contact at the investment banking firm, indicates that a key appeal of this merger to Flavoring would be Fashion's greater financial flexibility and access to lower cost sources of financing for expansion of its products in new geographic areas. Fashion has a very attractive performance based stock option plan. Flavoring's incentive plan is entirely based on cash compensation for achieving performance goals. Additionally, the 80% of Fashion's stock not controlled by management interests is very widely held and trades actively. Flavoring became a publicly held company three years ago and doesn't trade as actively.

Silver has asked Smith to prepare a report summarizing key points favoring the acquisition and an acceptable acquisition price. In preparing his report, Smith relics on the following financial data on Fashion, Flavoring, and four recently acquired food and beverage companies.

The least likely reason that Flavoring's management would favor an acquisition by Fashion would be:

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Correct Answer: C

Opportunities to expand its products in different segments of the market for spices are not indicated in the vignette. Flavoring's management appears more interested in geographic expansion of its existing product line. (Study Session 9, LOS 31.b)



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