Mock Test Session 1 – Question Sheet

Case No. 1
Daniel Nguyen is a CFA Level II Candidate who was recently
hired as a junior analyst at Broadscope & Company.
Broadscope is an investment bank based in the United States
whose clients include large multinational entities. Broadscope
offers investment banking and investment advisory services,
and it conducts sales and trading in many countries around the
world. In some countries, securities laws and regulations are
less strict than those in the US, while in other countries, the
laws are more strict.
When underwriting securities outside the United States,
Broadscope enters into a syndication agreement with
investment banks located in the countries where the securities
will be sold. The syndication agreement explicitly states that
the local investment banks in a given country are responsible
for ensuring that sales of all securities within that country
comply with local laws and regulations.
Nguyen is assigned to a group that is underwriting an issue of
callable bonds by Stone Industries in several countries,
including the United States and Country A. Country A permits
only accredited investors to invest in derivatives, and Country
A's laws treat callable bonds as derivative securities. Nguyen's
supervisor, Farah Baghdadi, CFA, is aware of this restriction, but
Nguyen is not. The local investment bank in Country A sold
some of the bonds to nonaccredited investors.
During the underwriting process, Nguyen spoke frequently with
Paul Marchesse, a senior analyst at Stone Industries, about
issues relating to the underwriting. During one of these
conversations, Marchesse told Nguyen, "I've heard from a
couple of sources at Barstow Conglomerates that they really like
what Broadscope has been able to do for Stone Industries and
they are considering giving Broadscope some underwriting
business." Nguyen relayed this information to Baghdadi, who
accordingly advised Broadscope's business development team.
Vincent Pardew, CFA, is a senior vice president with Broadscope
who leads the sales team in the United States for the Stone
Industries bonds. Twenty institutional clients expressed
interest in purchasing the bonds, but based on their investment
policy statements, Pardew concluded that the bonds would be
suitable for only five of them. In addition, three of those five
clients had discretionary accounts with Broadscope; the other
two were nondiscretionary.
The Stone Industries issue was greatly oversubscribed. In
total, the clients for whom Pardew believed the bonds
would be suitable placed orders for $10 million in face
value for the bonds, but Pardew received only $4 million in
face value. Pardew allocated the bonds only to the
discretionary clients on a pro-rata basis.

Nguyen wants to take a second job to generate more

income. He contacts Cleaner Air Products, for whom he
worked as an inventory clerk during college. Cleaner Air
Products offers him his former position, and he arranges
the schedule so that it does not conflict with his duties at
Broadscope. Before accepting, however, he asks Baghdadi
to approve this arrangement. Baghdadi replies, "Yeah, I
guess so. Just make sure it doesn't interfere with what
you're doing for us."
Case No. 1
Case No. 2
Modesto Gallardo is an equity analyst at an asset
management firm. One of the firm's portfolio managers
asks Gallardo to analyze Legado Bank, a local commercial
bank. Gallardo decides to start his analysis using the
CAMELS approach and Legado's key performance ratios,
which are shown in Exhibit 1:

Gallardo is concerned about the quality of Legado Bank's

earnings. He analyzes the bank's income statement,
looking for signs of potential problems. Summarized data is
presented in Exhibit 2:

Gallardo knows that Legado Bank offers a defined benefit

pension plan to all its employees. In 20X2, the bank
reported a net pension asset in its balance sheet. Gallardo
wants to better understand the plan's pension obligation
and funding status and asks his colleague, Irina Belda, for
support on this issue. Belda makes the following
statements:
Statement 1: The pension obligation is the difference
between the PV of future obligations and the fair value of
the plan's assets.
Statement 2: The discount rate is based on the plan
sponsor's cost of debt.
Statement 3: The plan surplus may be greater than the
reported net pension asset.
Belda informs Gallardo that companies typically report
important information about their pension plans in the
notes to the financial statements. For example, Legado
Bank presents the effects that potential changes in pension
plan assumptions would have on pension obligations.
Gallardo uses Exhibit 3 to estimate how a 1 percentage
point increase in the discount rate would affect Legado
Bank's debt-to-equity ratio. Currently, the bank's
shareholders' equity is €47 billion and total liabilities are
€517 billion.
Case No. 1
Case No. 3
Romeo Bulan, an equity analyst at Quezon Capital,
considers a stock to be over- or undervalued in the market
if the stock's price differs by more than 5% from his
valuation. Bulan is evaluating the investment prospect of
Candon, a packaged food producer. On the first day of
20X2, Candon's current share price is $55.50. Selected
forecasted financial data are presented in Exhibit 1:

Bulan also forecasts the following specific financial line

items and assumes growth in free cash flow to equity
(FCFE) will match the long-term earnings growth rate
beginning in 20X5:

Next, Bulan focuses on Tangub, a retail drugstore chain that

currently has a market price of $60 per common share.
Bulan compiles the following selected 20X1 financial
information in Exhibit 3 to conduct a relative valuation
analysis:
Bulan also collects drugstore industry data for his relative
valuation analysis, as presented in Exhibit 4:

Later that day, Bulan discusses the merits of various

valuation methods with a colleague. Bulan states that,
relative to a FCF model, residual income (RI) models:

Statement 1: Require minimal accounting data input

adjustments
Statement 2: Are less reliant on terminal value estimates
Statement 3: Provide a more accurate intrinsic value
estimate
Case No. 1
Case No. 4
Kayla Gharib is a macro strategist at a university
endowment. Nora Jabari is an investment analyst at the
endowment and works closely with Gharib. Gharib and
Jabari are discussing key macro assumptions that affect the
endowment's investment portfolio.

Jabari provides a recap of current macro interest rate

conditions:

Over the past year, inflation has averaged 3%.

The real yield on the one-year inflation-protected
government bond is currently −2%.
The current break-even inflation rate is 2%.
The market's consensus is that the business cycle appears
to have peaked, the yield curve has inverted, and an
economic contraction seems imminent. The central bank
has indicated a policy bias toward easing monetary policy,
and current market expectations are for the policy rate to
be lowered by 1% over the coming year, with an associated
parallel shift in the yield curve.

Based on this macroeconomic backdrop, Gharib and Jabari

discuss the upcoming investment prospects for several
bond indexes, all of which have a five-year average maturity
and four-year duration profile.

Jabari makes the following statement regarding the one-

year return outlook for the indexes:

Statement 1: Since the interest rate risk is the same for all
three indexes, all three should benefit equally from falling
interest rates and have similar performance.
Gharib counters by stating:

Statement 2: The investment grade corporate index

should outperform the government bond index.
Statement 3: The high yield index is likely to be the best
performer as it has an inherent yield advantage.
Shifting the focus of the conversation to corporate earnings
growth expectations in relation to the business cycle,
Gharib makes the following observations:

Observation 1:A leading indicator of the business cycle is

the trend in corporate profit margins.
Observation 2:A downturn in the business cycle will
generally result in an equal decline in profit margins across
durable and nondurable industries.
Observation 3:A sharp decline in real earnings nearly
always coincides with a recession.
With the potential for a downturn in the business cycle, the
conversation shifts once again to the consumption hedging
properties of bonds and equities. Jabari makes the
following comments:

Comment 1: The equity risk premium can be thought of

as a spread relative to credit-risky bonds.
Comment 2: The consumption hedging properties of
equities are a fundamental driver for investors to demand
an equity risk premium.
Case No. 1
Case No. 5
Domenic Guimond is a principal at Mintaka Partners, a
venture capital (VC) firm. In 20X7, Mintaka invested in
CardShield, a cybersecurity start-up that uses artificial
intelligence to prevent credit card fraud. Due to
CardShield's impressive performance in predicting and
preventing fraud, its client base and growth prospects
increased substantially in 20X8, attracting more investors
for a Series B financing.

Guimond asks Tatiana Goyette, a junior associate, to

calculate the firm's implied ROI after this second round of
financing. Goyette prepares data (shown in Exhibit 1)
related to CardShield's financing by Mintaka and other
investors in 20X7 (Series A) and by other VC funds in 20X8
(Series B).

Guimond adds that the estimated return reflected in the

implied ROI is based on the current valuation level, but the
actual return will depend on other factors, such as the
chosen exit route and the exit timing. He asks about the
differences between alternative exit routes, and Goyette
makes the following statements:

Statement 1: An IPO is a more common exit alternative

than a secondary market sale.
Statement 2: A secondary market sale typically results in a
greater valuation than a management buyout (MBO).
Statement 3: An IPO aligns the interests of management
and investors more efficiently than an MBO.
Guimond then focuses on Mintaka Capital 3 (MC3), the VC
fund that holds the investment in CardShield, among other
start-ups. He asks Goyette to gather information about the
capital already called down, operating results, fees, and
distributions to limited partners. Goyette prepares Exhibit
2 with the accumulated amounts since the fund's inception
in 20X4:

Goyette tells Guimond that she would like to better

understand the structure and life cycle of private equity
(PE) funds. Guimond lists the following characteristics of PE
funds:

Characteristic 1: The liability of limited partners is

limited to their proportional share of the fund's liabilities.
Characteristic 2: Proceeds from sales of investments
are returned to limited partners when the fund is dissolved.
Characteristic 3: PE funds typically have a duration of
10 to 12 years plus an extension of 2 to 3 years.
Case No. 1
Case No. 6
Aditya Lanka manages a bond fund for an asset
management company, and Arina Skya is a fixed-income
analyst on his team. Lanka and Skya discuss the use of
binomial interest rate trees for valuing straight debt
securities and bonds with embedded options. During the
discussion, Lanka asks Skya to explain pathwise valuation
for a single interest rate path. Skya describes two
alternative approaches to pathwise valuation that result in
the same value:

Approach 1: Use period-by-period discounting along a

single interest rate path, from maturity to Time 0.
Approach 2: Sum the PV of all periods' cash flows, with
each discounted by the appropriate term spot rates implied
by that interest rate path.
On Aug 15 20X3, Lanka asks Skya to develop a binomial
interest rate tree to evaluate three 3-year bonds of Tiptri
Corporation being issued that day. Information on the
bonds is shown in Exhibit 1:

Exhibit 2 contains the binomial tree developed by Skya:

Lanka and Skya then discuss the arbitrage-free valuation of
the Tiptri convertible callable bond. Skya makes the
following comments about the possible range and
limitations of the bond's no-arbitrage price:

Comment 1: When the market price of Tiptri's common

stock is less than the bond's conversion price, the bond will
trade at a discount to its conversion value.
Comment 2: Once the bond becomes callable, the bond
should not trade at more than a slight premium to its call
price.
Comment 3: When the bond is considered a busted
convertible, its minimum value is the value of an otherwise
equivalent nonconvertible bond.
Assume all interest rates are annual compound rates.
Case No. 1
Case No. 7
Sommay Siwong is the senior portfolio manager of an asset
management firm. Siwong is considering increasing the
firm's exposure to Seginus Stores, a large chain of home
furnishings stores. Seginus's management recently issued a
press release announcing its intention to acquire 100% of
Hamal Home, a smaller company that operates in the same
segment.

Siwong directs Janjira Tay, an equity analyst who reports to

him, to perform an initial evaluation of the acquisition. He
makes the following statements to guide her analysis:

Statement 1: The acquisition costs 35% of Seginus's EV but

does not change Seginus's strategy or focus, so it is
considered immaterial.
Statement 2: The greater the size and complexity of the
transaction, the longer the timeline from announcement to
closing.
Statement 3: Comparable company analysis is used to
understand the acquisition and its motivations.
After analyzing Seginus's and Hamal's 20X9 forecasted
income statements, Tay creates a combined income
statement considering the acquisition. She explains to
Siwong that the combined statement incorporates
assumptions of synergies and acquired intangible assets
and that cash costs related to the combination are
insignificant. She presents the statements in Exhibit 1:
Tay also gathers the following information based on
Seginus's press release and on its financial statements:

Before the acquisition, Seginus had annual interest

expenses of $50 million and 200 million outstanding shares.
Hamal does not have any debt.
To finance the acquisition, Seginus expects to issue $500
million in additional debt (at an annual cost of 6%) and 50
million new shares.
Seginus's effective tax rate is expected to remain stable at
25%.
Siwong turns his attention to Bubbles Bev, a manufacturer
of soft drinks. Recently, Bubbles entered the energy drinks
market, which has been growing faster than the soft drinks
segment. Bubbles' management believes that the company
is currently trading with a conglomerate discount and
studies a potential sale or spin-off of its soft drinks
segment.

Siwong requests the most recent data about Bubbles's

capitalization and EV multiples in the beverage industry.
Tay gathers this market data, summarized as follows:

Bubbles has 200 million shares outstanding at a market

price of $35.00 per share.
Bubbles' debt has a market value of $4.0 billion.
Peers in the soft drinks segment have a median EV-to-
EBITDA multiple of 8.0.
Peers in the energy drinks segment have a median EV-to-
sales (EV/S) multiple of 12.0.
Tay also presents Bubbles' most recent financial data by
segment in Exhibit 2:
Case No. 1
Case No. 1
Case No. 8
Mariel Olidan manages an option trading desk for Bearing
Brothers (BB), a global investment bank where Jare Fento is
a trader. During a discussion of option pricing models,
Olidan asks Fento to explain how the Black-Scholes-Merton
(BSM) model values European equity options.
Then Olidan asks Fento to explain the differences between
the BSM model for valuing equity options and the Black
model for valuing equity futures options. In particular,
Olidan wants to understand the reasons why the two
models typically calculate different no-arbitrage values for
seemingly similar equity and futures options (ie, both
options at the money with the same time to expiration).
Fento makes two statements to explain the differences in
value between the two types of options:
Statement 1: The primary difference between the values
of similar equity options and equity futures options is due
to differences in carry costs, which are significantly higher
for equities than for a futures contract.
Statement 2: The BSM model equity option values reflect
the difference between the PV of the equity price and the
PV of the option exercise price; the Black model equity
futures option values reflect the PV of the difference
between the futures price and option exercise price.
The BB trading desk is currently short 1,000 1-month
Pontus Corporation calls with a 120 strike price. Olidan
wants to hedge the position before the current trading
session ends since Pontus will announce earnings shortly
after the market closes. Olidan asks Fento to identify
possible strategies to make the short call position delta
neutral. Exhibit 1 contains information on Pontus stock and
1-month options Fento is considering for the delta-neutral
strategy.
Olidan and Fento notice that implied volatility (vol) has
generally increased for options on most equities. During
the discussion of the general rise in implied vols, Fento
provides two possible explanations:

Explanation 1: Higher implied vols indicate the price of risk

has increased, which means a greater cost to hedge risk
with long options.
Explanation 2: Higher implied vol can be driven by an
imbalance between the supply and demand for options in
which, on balance, there are more speculators and hedgers
seeking to sell options than the number of such traders
seeking to buy options.
All options discussed by Olidan and Fento are European
options, and each option contract is on one share of the
underlying stock.
Case No. 1
Case No. 9
Pierre LeBlanc is an emerging markets strategist at a buy-
side firm. LeBlanc is discussing the investment prospects of
various emerging market countries with Noelle Roche, the
portfolio manager for the firm's emerging market fund.
Roche is particularly concerned about Nazca, an emerging
market country in South America where the fund has
several investments.
Nazca's currency is pegged to the US dollar (USD). Nazca
has embarked on aggressive expansionary fiscal and
monetary policies over the past several years, resulting in a
sizeable trade and current account deficit. This deficit was
funded primarily with short-term dollar-denominated debt
sold to foreigners.
Nazca recently signed a free trade agreement with the
United States that the two countries had been working on
for several years. Over the past few years, in anticipation of
the deal closing, there has been a surge of capital inflows,
and local companies have significantly increased debt levels
to build the infrastructure necessary for taking advantage of
the free trade environment. The net effect of these
developments has put significant upward pressure on
Nazca's currency.
Recently, capital flows appeared to hit a key inflection point
and have reversed dramatically over a short period of time.
Speculators and other leveraged market participants have
begun aggressively selling the local currency. To maintain
the currency peg, the country's central bank has been
buying the local currency, but the cost of issuing new debt
has become prohibitive and the central bank's reserves are
almost exhausted. In response to these developments,
Nazca's central bank has announced capital controls that
prevent foreign investors from repatriating funds.
Based on these events, LeBlanc believes the following
outcomes are likely:
Outcome 1: Most investors will view the capital controls
favorably, easing selling pressure on the local currency.
Outcome 2: Nazca's currency will appreciate, and the
central bank will reset the peg with the USD to a higher
level.
Roche is also concerned about Nazca's geographic neighbor
Atacama, which has taken a completely different path
toward trade. Over the past several decades, Atacama
developed inward-oriented policies allowing domestic
industries to develop locally produced substitutes for goods
previously imported.
Atacama's GDP per capita remains low, and growth has
stagnated. There is also a large informal economy and
workforce. The country is now considering policy changes
in an attempt to increase its GDP growth and standards of
living.
LeBlanc lists Atacama's proposed new policies:
Policy 1: Lower the income tax rates.
Policy 2: Encourage foreign direct investments to
build factories that focus on exports.
Policy 3: Impose higher tariffs on imports of goods
produced by certain protected domestic industries.
The conversation then shifts to a discussion on the
characteristics of developed versus developing markets.
LeBlanc argues that numerous factors limit growth in
developing countries relative to developed countries. For
example, he cites antitrust regulation as a key protection
for investors in developed markets.
LeBlanc continues by stating that, relative to developed
countries, economic growth in developing countries is
limited by the following key factors:
Factor 1: High savings rates that result in an inefficient
allocation of capital, reducing investment
Factor 2: Regulatory policies that discourage
entrepreneurship
Factor 3: Poorly developed financial markets, which
inhibit capital formation
Case No. 1
Case No. 10
Globetechz is a multinational corporation headquartered in
Germany with subsidiaries and investments across the
world. Globetechz adheres to IFRS reporting standards.
On Jan 1 20X1 Globetechz acquired 30% of Floridex, a
German manufacturer, for €3,600,000. Globetechz will use
the equity method to account for its investment in Floridex.
On Jan 1 20X1, the book value of net assets was
€10,000,000.
During 20X1, Floridex sold €120,000 of inventory upstream
to Globetechz for €150,000. On Dec 31 20X1, €30,000 of
that inventory remained unsold by Globetechz.
Floridex reported net income of €800,000 for 20X1 and paid
€100,000 in dividends.
Heidi Holmon is Globetechz's new chief strategy officer.
She recently came to the company from a large US-based
competitor that reports under US GAAP. Holmon is
unfamiliar with IFRS rules for intercorporate investments
and asks Gretchen Goodman, the chief accounting officer,
to explain some of the differences. Goodman cites the
following differences:
Difference 1: Under US GAAP, the fair value option is
available for all equity method investments. Under IFRS,
the fair value option is available only to certain
organizations, such as venture capital firms and unit trusts.
Difference 2: US GAAP require objective evidence of one
or more events that resulted in a loss in order to record
impairment on an investment in an associate, whereas with
IFRS, impairment is recorded when the fair value of the
investment falls below its carrying value.
Difference 3: Under the acquisition method, both US
GAAP and IFRS allow for recognition of partial goodwill.
Goodman then focuses on the effective tax rate for
Globetechz over the past three years. All of Globetechz's
foreign subsidiaries operate in countries with higher
corporate tax rates than Germany. She notices that the rate
has been increasing (as shown in Exhibit 1) and wants to
find the cause.
Finally, Holman and Goodman assess several operating
segments for sales performance, as shown in Exhibit 2:
Case No. 1
Case No. 11
Simba Sefu is the Chief Strategy Officer at Safri Co., a large
financial institution. Safri has achieved remarkable organic
growth but plans to expand through acquisitions in the near
future. Sefu meets with Nuru Narla, the corporate
development manager at the firm, to discuss potential
acquisition targets.

They first review several technology companies in distinct

verticals. Narla plans to value each company using the
market-based valuation approach. She gathers a
comparable market value of invested capital-to-EBITDA
(MVIC-to-EBITDA) reference for each potential target
company (shown in Exhibit 1). Sefu asks which transaction
would warrant a valuation premium adjustment with
respect to its MVIC-to-EBITDA reference.

Next, they assess Ranko Tech, a fintech software startup

with a unique proprietary platform that is rapidly capturing
a growing customer base. No other competition exists in
this space. Although Ranko has experienced rapid growth,
it has reported negative earnings in the past year due to
significant trade-show promotional expenses. Normalized
earnings would have been significantly positive after
adjusting for these expenses and are expected to
continually grow for the foreseeable future. Based on this
profile, Sefu tries to determine the appropriate valuation
methodology.
They then focus on Jengo LLC, a luxury goods lending
company. To value Jengo, they need to determine the
appropriate discount rate. Due to Jengo's small size, its
debt capacity is very low and its financial statements are
unaudited; the company has historically experienced
challenges in accurately forecasting financial results. Narla
comments on several factors to consider when estimating
Jengo's discount rate:

Comment 1: Using expanded CAPM to calculate Jengo's

discount rate requires adding an industry premium.
Comment 2: Due to its lower debt capacity and reliance
on other sources of capital, Jengo would have a lower
discount rate compared with otherwise similar public
competitors.
Comment 3: The discount rate should be adjusted upward
for the lack of reliable financial forecasts.
Finally, they consider Lasco, a wealth management firm.
Narla gathers the following information in Exhibit 2 to value
100% of Lasco using the Guideline Public Company Method
(GPCM):
Case No. 1