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CFA LEVEL 2 - TEST BANK WITH SOLUTIONS

Question: Analyze the advantages and disadvantages of the variousnancial and operating changes that a company can make to manage itssustainable growth.

Answer:

The frst step in solving the excess growth problem is to determine i the situationis temporary or permanent. I temporary, urther borrowing may be the simplesolution. I longer-term, some combination o the strategies described below willbe necessary:

1. Sell New Euity- I the company is willing and able to raise new euity capitalby selling shares, its sustainable growth problems vanish. The increased euity,plus whatever added borrowing is possible as a result o the increased euity, is asource o cash with which to fnance urther growth. The potential problems with

this strategy are:

!. "oorly developed or non-existent euity mar#ets ma#e euity di$cultto sell, basically ma#e the shares illiuid.

%. &imited access to the services o an investment ban#er to sell theshares, which is especially true or small concerns.

'. (any companies may preer not to sell euity, opting instead orinternal sources, depreciation and increases in retained earnings assources o corporate capital.

). !ncrease leverage - Increasing leverage raises the amount o debt thecompany can add or each dollar o retained profts. There are limits to the use odebt fnancing: all companies have a creditor-imposed debt capacity that restrictsthe amount o leverage the frm can employ. (oreover, as leverage increases, theris#s borne by owners and creditors rise, as do the costs o securing additionalcapital.

*. "educe the #ayout "atio- ! cut in the payout ratio raises sustainable growthby increasing the proportion o earnings retained in the business. In general,owners+ interest in dividend payments varies inversely with their perceptions othe company+s investment opportunities. I owners believe that the retained proftscan be put to productive use within the company, they will orego currentdividends in avor o higher uture ones. !lternatively, i a frm+s investmentopportunities do not promise attractive returns, a dividend cut will angershareholders, resulting in astoc# price decline.

. #rotable #runing - "roftable pruning sells o marginally perormingoperations to invest the money into the remaining businesses. This approachrecognies that when a company spreads its resources across too many products,it may be unable to compete eectively in any. "roftable pruning reducessustainable growth problems in two ways: it generates cash directly through thesale o marginal businesses, and it reduces actual sales growth by eliminatingsome o the sources o the growth.

/. "roftable pruning can also be applied to a single-product company. In this case,slow-paying customers and0or slow-turning inventory is eliminated. This can

Norman Cheung 1 AllenResources_Q&A_Level 2

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eliminate sustainable growth problems in three ways: It rees up cash it increasesasset turnover and it reduces sales.

2. Sourcing - This option involves deciding whether to perorm an activity in-house or to purchase it rom an outside vendor. 3ourcing more and doing less in-house may increase sustainable growth rate. 3ourcing releases assets that wouldotherwise be tied up in perorming an activity, and it increases asset turnoverboth o which serve to diminish growth problems. The #ey to eective sourcing isdetermining where the company+s uniue abilities lie, and sourcing out tas#s thatare not core to the business.

4. #ricing - !n obvious inverse relationship exists between price and volume.5hen revenue growth is too high in relation to a company+s fnancing ability, itmay have to raise prices to reduce growth. I the higher prices increase the proftmargin, the rate o sustainable growth may increase.

6. $erger- 5hen all else ails, it may be necessary to loo# or a partner. Twotypes o companies are capable o supplying the needed cash: a mature company

7a cash cow8 loo#ing or proftable investments or its excess cash 9ow and aconservatively fnanced company that would bring liuidity and borrowing capacityto the cash needy frm.

Question% E&plain the computation of a rm's e(ective ta& rate.

Answer:

"ermanent dierences, which are dierence between the way that the tax codemeasures income and the way that fnancial statements report income that neverreverses itsel, aect the provision or taxes in the income, the tax expense, whichis calculated as:

7"roected income beore taxes - "ermanent dierences8 x tax rate

Timing dierences, which are dierence between the time that the tax coderecognies either an income or an expense item and the time at which thefnancial statements record the item, appear in the balance sheet as ;eerred

Taxes. ;eerred taxes are tax obligations that are expected to bepaid when the timing dierences are reversed. ;eerred taxes in any fscal yearare calculated as:

7'umulative timing dierences8 x 7tax rate8

! tax payment or a given year euals the tax expense minus the increase in thedeerred tax account.

5hen analying the tax accounts, the obective is to estimate three elements:

1. The permanent dierences that the frm will have between its taxable income and reported income.). The timing dierences.*. The tax rate to which the frm will be subect.

The frst step in determining these elements is the calculation o:

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Question% Evaluate the most commonly found indenture provisions.

Answer:

UTILITY INDENTURES

1. >Security> specifes the property upon which there is a mortgage lien and theran#ing o the new debt relative to outstanding debt is specifed. ?enerally, newbonds ran# eually with all other bonds outstanding under the mortgage. 'ertaineatures o older provisions have become archaic,hindering the e$ciency o running a business. Thereore, a company will attemptto retire old debt in order to eliminate the more restrictive covenants not includedin current oerings.

). >Issuance of Additional Bonds> establish the conditions under which thecompany may issue additional frst mortgage bonds and is oten based upon adebt test and0or earnings test. The debt test generally limits the amount o bonds

that may be issued under the mortgage to a certain percentage o net property ornet property additions, the principal amount o retired bonds, and deposited cash.

The earnings test restricts issuance o additional bonds under the mortgage unlessearnings or a particular period cover interest payments at a specifed level.

*. >Maintenance and Replacement (M&R) Fund> ensure that the mortgagedproperty is maintained in good operating condition, thereby maintaining its value.

. >Redemption Provision,> or call provision specifes when and under whatprices a company may call its bonds. @eunding is an action by a company toreplace outstanding bonds with another debt issue sold at a lower interestexpense.

/. >Sinin! Fund> is an annual obligation o a company to pay an amount o cashto a trustee in order to retire a given percentage o bonds. This reuirement canoten be met with actual bonds or with pledges o property. The obligation can bemet by the stated percentage o each issue outstanding, by cash, or by applyingthe whole reuirement against one issue or several issues.

2. "t#er Provisions. These include events o deault, mortgage modifcation,security, limits on borrowing, priority, and the powers and obligations o thetrustee.

INDUSTRIAL INDENTURES

1. >$e!ative Pled!e %lause> provides that a company cannot create or assumeliens to the extent that more than a certain percentage o consolidated nettangible assets without giving bondholders the same security.

). >imitation on Sale and ease'ac ransactions> provide protection or thebondholder against the company selling and then leasing bac# assets that providesecurity or the holder. This provision reuires that assets or cash eual to theproperty sold and leased bac# be applied to the retirement o the debt in uestionor used to acuire another property or the security o the bondholders.

*. >Sale of Assets or Mer!er> protect bondholders in the event o the sale o

substantially all o the company+s assets by reuiring that the debt be retired orassumed by the merged company.


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. >ividend est> establishes rules or the payment o dividends so bondholderswill be assured that the company will be not be drained by dividend payments.

/. e't est: This provision limits the amount o debt that may be issued byestablishing a maximum debt0assets ratio.

FINANCIAL INDENTURES

1. >Sinin! Fund and Refundin! Provisions> speciy sin#ing und and reundingprovisions. ?enerally, fnance issues with a short maturity are non-callable,whereas longer issues provide 1A-year call protection.

). >ividend est> is the most important provision or a bondholder o a fnancesubsidiary. It restricts the amount o dividends that can be upstreamed to theparent rom the subsidiary, thereby protecting the bondholder rom the parentdraining the subsidiary.

*. >imitation on iens> restrict the degree to which a company can pledge itsassets without giving the same protection to the bondholder.

. >Restriction on e't est> limit the amount o debt the company can issueand is generally stated in terms o assets and liabilities although an earnings testis sometimes used.

Question% )ompare market*based forecasts with model*based forecastsof foreign e&change rates.

Answer:

In a fxed rate system, orecasters ocus on governmental decision ma#ing,sincethe decision to devalue or revalue a currency is political. In a 9oating rate system,where there is little or no government intervention, currency orecasters usemar#et or model based orecasts. In a mar#et-based orecast, exchange rates areorecast by loo#ing at interest and orward rates. In general, the orward rate isused as the unbiased predictor or uture spot rates. This can only be used topredict exchange rates or up to a year in advance, since orward contractsgenerally don+t exist or periods beyond one year. Interest rate dierentials areused to predict exchange rates ater one year.

The two main model-based orecasting tools are undamental and technicalanalysis. Bundamental analysis loo#s at macroeconomic variables and policies thatmight aect a currency. These variables include in9ation and interest rates,national income growth and changes in the money supply. Bor example, i thecurrent in9ation rates and spot rates or two currencies are #nown, then the uturespot rate can be predicted using """. The problem with undamental analysis isthat it is di$cult to predict which variables are the right ones, and then to predictwhat these variables will do in the uture. I the undamental values the analystcalculates are the same as the values that the mar#et calculates, then because oe$cient mar#ets exchange rates will already re9ect these calculations. In addition,there is generally a lag between the time that changes in variables are expectedto occur and when these variables actually impact exchange rates.

Technical analysis ocuses on past price and volume movements to orecastexchange rates. This can only be successul i there are price patterns that are


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discernable and then repeated so traders can ta#e advantage o them. In charting,analysts loo# at graphs to spot price patterns and with trend analysis, trend-ollowing systems are used to predict price trends.Question% !dentify factors and potential developments that would alterinvestors' e&pectations.

Answer:

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necessary.

1. Sell $ew *+uity- I the company is willing and able to raise new euity capitalby selling shares, its sustainable growth problems vanish. The increased euity,plus whatever added borrowing is possible as a result o the increased euity, is asource o cash with which to fnance urther growth. The potential problems withthis strategy are:

!. "oorly developed or non-existent euity mar#ets in some areaso the world ma#e euity di$cult to sell, basically ma#ing theshares illiuid.

%. 3mall companies may have limited access to the services o aninvestment ban#er to sell the shares, ma#ing it di$cult to place anew issue.

'. (any companies may preer not to sell euity, opting instead orinternally generated unds, such as depreciation and increases in

retained earnings, as sources o corporate capital.

). Increase levera!e - Increasing leverage raises the amount o debt thecompany can add or each dollar o retained profts. There are limits to the use odebt fnancing. !ll companies have a creditor-imposed debt capacity that restrictsthe amount o leverage the frm can employ. (oreover, as leverage increases, theris#s borne by owners and creditors rise as do the costs o securing additionalcapital.

*. Reduce t#e Payout Ratio- ! cut in the payout ratio raises the sustainablegrowth rate by increasing the proportion o earnings retained in the business. Ingeneral, owners+ interest in dividend payments varies inversely with their

perceptions o the company+s investment opportunities. I owners believe that theretained profts can be put to productive use within the company, they will oregocurrent dividends in avor o higher uture ones. !lternatively, i a frm+sinvestment opportunities do not promise attractive returns, a dividend cut willanger shareholders and result in a decline in stoc# price.

. Pro,ta'le Prunin!- "roftable pruning sells o operations that are perormingmarginally to generate cash to invest in the remaining businesses. "roftablepruning reduces sustainable growth problems in two ways: it generates cashdirectly through the sale o marginal businesses, and it reduces actual salesgrowth by eliminating some o the sources o the growth.

"roftable pruning can also be applied to a single-product company. In this case,slow-paying customers and0or slow-turning inventory are eliminated. This caneliminate sustainable growth problems in three ways: by reeing up cash, byincreasing asset turnover, and by reducing sales.

/. Sourcin!- 3ourcing more and doing less in-house may increase sustainablegrowth rate. 3ourcing releases assets that would otherwise be tied up inperorming an activity, and it increases asset turnover both o which serve todiminish growth problems.

2. Pricin!- 5hen revenue growth is too high in relation to a company+s fnancingability, it may have to raise prices to reduce growth. I the higher prices increase

the proft margin, the rate o sustainable growth may increase.


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4. Mer!er- 5hen all else ails, it may be necessary to loo# or a partner. Twotypes o companies are capable o supplying the needed cash: a mature company7a cash cow8 and a conservatively fnanced company that would bring liuidity andborrowing capacity to the cash needy frm.

Question% +iscuss the weaknesses and di,culties of using ratio analysisto evaluate a company.

Answer%

There are three primary methods by which ratios are udged:

1. )-$#A"!N "A/!-S )"-SS SE)/!-NA001This involves comparing a ratio in a particular frm to the same ratio in othersimilar frms. The obective is to determine i the ratio that is being analyed istoo high or too low in comparison to the norm. 3ince there are no completelyidentical frms, an analyst decides how tight the criteria should be between

frms. The tighter the criteria the better. Dowever, guidelines that are toospecifc will eliminate many comparables.

I an abnormal ratio is discovered, it may simply be a result o the frm+s uniuepolicies, and is thereby no reason or concern.

). /2E /!$E SE"!ES -3 /2E 3!"$'S "A/!-S!s mentioned above, the problem with comparing ratios cross sectionally is thatno two frms are identical. Cne way to correct this problem is to the use the frmto establish the norm or the dierent ratios, which is done by analying the timeseries o the frm+s ratios. This is accomplished by comparing a ratio over timeand examining its trend. The reasoning behind this method is that since each

frm+s uniue eatures determine its ratios, reviewing trends in the ratios canidentiy changes in the frm+s operations.

!lthough this method is an improvement over the cross sectional comparisonmethod, it still has the ollowing problems:

First, intentional and unintentional changes in a frm+s policies lead to thechanges in the ratio that cannot be unraveled by an outside analyst. Borexample, a decline in a frm+s gross margin may result rom a variety o reasons,and because fnancial statements summarie events, trends are not easy tointerpret.

Second, in9ation may cause alse trends among various ratios because fnancialreporting is done on a historical-cost basis. Bor example, depreciation expensewill probably re9ect the cost o assets that are several years old, and since thecost o goods sold or an industrial frm includes these depreciation charges, thegross-margin ratio may appear to >improve> over time.

Finally, the use o past ratios as the norm against current ratios may disguiseproblems, or even strengths, o the frm.

Thus, a complete ratio analysis should include both a cross-sectional and a time-series comparison o ratios.

*. /2E E)-N-$!) !N/E"#"E/A/!-N -3 "A/!- )2ANES AN+ +E4!A/!-NSThe ratios that are obtained or a frm should be compared to our economic


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understanding o the frm+s environment, business, policies, and eectiveness.This is what dierentiates a technically correct but uninormative fnancialstatement analysis rom an analysis that provides insights into the frm+soperations and allows accurate prediction o its uture fnancial perormance.

Question% )ompare and contrast the monthly prepayment optionembedded in an $5S with a callable or putable bond and with a non*callable bond.

Answer%

!n investor+s ris# can be illustrated using the concept o convexity. 5hen interestrates decline sharply, convexity becomes negative. In a mortgage pool, anincreasing portion o the mortgages in the pool prepays. 5hen interest ratesdecline below the coupon rate, most people prepay and the price-yield relationshipexperiences negative convexity in this area.

Bor higher interest rates, negative convexity also may occur, or there will at leastbe less positive convexity than is the case with bonds. The reason or this is thatpeople who might want to upgrade their house or to relocate are discouraged todo so because o the much higher payments on the new home. In this case,prepayments are below what would normally occur, which is #nown as extensionris#. ;uration o the instrument increases and i the term structure is upward-sloping, the value decline is more than occurs with a fxed-rate, stated-maturitybond.

The possibility o negative convexity in a high interest environment ma#esmortgage securities very dierent rom a noncallable, fxed-income security orwhich positive convexity prevails. 5ith all other things constant, or signifcant

interest-rate changes, a mortgage security will perorm more poorly than a fxed-rate stated maturity bond.

Question% State and describe the two main model*based currencyforecasting tools.

Answer%

The two main model-based orecasting tools are undamental and technicalanalysis. Bundamental analysis loo#s at macroeconomic variables and policies thatmight aect a currency. These variables include:

1. in6ation). interest rates*. national income growth. changes in the money supply

Bor example, i the current in9ation rates and spot rates or two currencies are#nown, then the uture spot rate can be predicted using """. The problem withundamental analysis is the di$culty in predicting which variables are the rightones, and then predicting what these variables will do in the uture. I thecalculated undamental values are the same as the values that the mar#etcalculates, the exchange rates will already re9ect these calculations. In addition,

there is generally a lag between the time that changes in variables are expectedto occur and when these variables actually impact exchange rates.


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Technical analysis ocuses on past price and volume movements toorecastexchange rates. This can only be successul i:

1. There are price patterns that are discernable). "rice patterns are repeated so traders can ta#e advantage o them

In charting, analysts loo# at graphs to spot price patterns. In trend analysis, trend-ollowing systems are used to predict price trends.

Question% /he idea that recessions will be more infreuent but will havegreater nancial implications when they do occur has a number ofimplications for 7.S. markets. 8hat are they9

Answer%

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In segmented mar#ets, the real interest rate in the F.3. is based on nationaldemand and supply. The real rate in the rest o the world is based on the rest othe world supply and demand. Bor example, suppose the F.3. real rate is higherthan the real rate outside the F.3.

I mar#ets are integrated, this will cause capital to 9ow into the F.3., decreasingthe F.3. real interest rate and increasing the rest o the world real interest rate. Inintegrated capital mar#ets, the home real interest rate depends on economicevents around the world. Today+s capital mar#ets are well integrated, meaningthere are only small real interest rate dierentials.

@eal interest dierentials are usually caused by currency or political ris#. Borexample, a real interest rate dierential could exist i investors strongly desiredomestic assets to avoid currency ris#, even i the expected real return on oreignassets were higher.

Question: +istinguish between the spot and forward markets for foreigne&change.

Answer:

Trading currencies occurs in oreign exchange mar#ets, whose primary unction isto acilitate international trade and investment. ! oreign exchange mar#et is theintermediary that allows trading o one currency or another.

In the spot mar#et, currencies are traded or immediate delivery, generally withintwo wor#ing days, while in the orward mar#et currencies are bought or sold oruture delivery. !bout 2AG o transactions are spot purchases and sales, about

1AG are orward contracts, and the remaining *AG are swaps, which involve bothspot deliveries and orward contracts.

(aor participants in the oreign exchange mar#et include large commercial ban#s,oreign exchange bro#ers, commercial customers such as multinationalcorporations, and government central ban#s. Boreign exchange bro#ers arespecialists in matching clients+ supply and demand needs. %ro#ers receive acommission on all transactions and supply inormation about buy and sell rates.

In the orward mar#et, the maor players are arbitrageurs, traders, hedgers andspeculators. !rbitrageurs ma#e the mar#et more e$cient by see#ing outdierences in interest rates between countries. They use orward contracts to tryto ma#e ris#-ree profts by exploiting these dierences.

Traders use orward contracts to reduce ris# on export or import orders bypurchasing or selling the currency that will be needed at some uture date.Dedgers, primarily multinational frms, use orward contracts to protect the homecurrency value o oreign-currency denominated assets and liabilities on theircompany balance sheets. These actions >loc# in> a currency price, reducing, oreven eliminating ris#. 3peculators, on the other hand, activelyexpose themselves to ris# by buying or selling currencies orward to beneft romexchange rate 9uctuations.

Question% +iscuss the characteristics of a swaption.


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Answer:

! swaption is an option on a swap that can be either !merican or

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(ichael "orter describes the competitive orces that determine the attractivenesso an industry and how to implement the principal strategies to achievecompetitive advantage. 'ompetitive advantage is created when the value a frm isable to create or its buyers exceeds the frm+s cost o creating it. Halue is whatbuyers are willing to pay or, and superior value stems rom oering lower pricesthan competitors or euivalent benefts or providing uniue benefts that morethan oset a higher price. "orter+s boo# describes two 'asic types ofcompetitive advanta!e:

1. )ost leadership, whereby a frm oers lower prices or the same productbenefts, and

). +i(erentiation, whereby buyers are willing to pay more or uniue beneftsthat a frm oers.Question% +i(erentiate between spot :cash; and futures prices ande&plain the why the basis must converge to zero at e&piration.

Answer%

The spot price, also reerred to as cash price or current price, is the price o a goodor immediate delivery. The uture price, that which will be paid at a specifc uturedate, is related to the cash price.

The basis is the relationship between the cash price o a good and the uturesprice or the same good. The basis is calculated as the current cash price or aparticular commodity at a specifed location, minus the price o a particular uturescontract or the same commodity at the same location.

basis < current cash price * futures price

ote that the basis calculated in considering utures prices may dier, dependingupon the geographic location o the spot price that is used to compute the basis.

?enerally, the basis is used in reerence to the dierence between the cash priceand the nearby utures contract. There is, however, a basis or each outstandingutures contract, and this basis will oten dier in systemic ways, depending uponthe maturities o the individual utures contracts.

In a normal mar#et, prices or more distant utures are higher than or nearbyutures. In an inverted mar#et, distant utures prices are lower than or the pricesor contracts nearer to expiration.

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The frst undamental determinant o a frm+s proftability is industryattractiveness. 'ompetitive strategy must grow rom a sophisticatedunderstanding o the rules o competition that determine an industry+sattractiveness. The ultimate goal o competitive strategy is to cope with andchange those rules in avor o the frm+s. In any industry, whether it is domestic orinternational, the rules o competition are embodied in fve competitive orces:

1. The entry o new competitors). The threat o substitutes*. The bargaining power o buyers. The bargaining power o suppliers/. The rivalry among the existing competition

These orces determine the ability o frms in an industry to earn rates o return oninvestment in excess o the cost o capital. The strength o these orces variesrom industry to industry. Bor example, in the pharmaceutical industry, all orcesare avorable so many competitors earn attractive profts. Jet in an industry where

pressure rom one or more orces is intense, such as rubber or steel, ewcompanies earn attractive returns even with the best o management.

The fve orces collectively determine industry proftability because they in9uencethe prices, costs and reuired investment o frms in an industry--the elements oreturn on investment. !ll industries dier in the individual and collective strengthso these orces and thereore, industries dier in inherent proftability. The strengtho each o the fve orces is a unction o industry structure, which is relativelystable, but can change over time as an industry evolves. The industry trends thatare the most important or strategy are those that aect industrystructure.

Birms are not prisoners o their industry structure, however. Through theirstrategies, frms can in9uence the fve orces and thereore shape industrystructure, ma#ing it either more or less attractive. There have been manysuccessul strategies that have changed the rules o competition through thismethod. Jet such strategies are a double-edged sword since a frm can destroyindustry structure and proftability as readily as it can improve it. Bor example, afrm that creates an improved product may undercut entry barriers or increase thecompetitive rivalry, but may undermine the long-run proftability o an industry.

Birms pursuing strategic choices without considering the long-term conseuenceso industry structure are termed >destroyers.> These frms are either: attempting tofnd ways to overcome competitive disadvantage, have serious problems and are

see#ing desperate solutions, or are frms that are so >dumb> that they do not #nowtheir costs or have unrealistic assumptions about the uture.

The ability o frms to shape industry structure places a particular burden onindustry leaders. &eaders+ actions can have a disproportionate impact on structure,because o their sie and in9uence over buyers, suppliers and other competitors.!t the same time, leaders+ large mar#et shares guarantee that anything thatchanges overall industry structure will aect them as well. &eaders, thereore,must stri#e a balance between its own competitive position and the health o theentire industry.

Question% 0ist the common causes of a decline in earnings uality.

Answer:


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Cne o the obectives o a uality o earnings analysis is to determine when therehas been a decline in the uality o earnings. The ollowing items are some o themore common causes o a decline in earnings uality:

1. !doption o less conservative accounting principles. Bor example, switchingrom &IBC to BIBC in an in9ationary environment, or changing rom accelerateddepreciation to straight line depreciation. This would also include capitaliing coststhat were previously expensed.

). !doption o less conservative accounting estimates, such as decreasingestimates o warrantee costs, bad debts, etc.

*. Cne-time transactions resulting in a recognied gain, such as sale o real estate.

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