2012 l2 sample exam v1 2 qa

Level II Version 1 2012 Sample Exam
McGuinn Case Scenario
Forster investment Advisors (FIA) is an asset management firm managing funds for both retail and
institutional clients. FIA also undertakes Investment Banking activities including market-making.
Recently, FIA’s Finance Director, who acted as the firm’s Compliance Officer, retired. The Board decides
to hire a part-time Compliance Officer on a consultancy basis rather than as a full-time employee, to
save costs.
FIA’s Managing Director asks Terry McGuinn, CFA, if he would be interested in being the Compliance
Officer on a part-time basis. McGuinn, an independent compliance consultant whose clients mostly
include pension funds, agrees to meet the Managing Director to discuss the position. At the meeting
McGuinn is told, “FIA adopted the CFA Institute Code and Standards ten years ago. The outgoing
Finance Director assured us at the time we adopted the Code that all of FIA’s policies and procedures
met the requirements of the Code and Standards and most of the recommendations as well. As a result
we mention compliance with the Code and Standards in all of our marketing material.” After agreeing on
terms and conditions, McGuinn accepts the offer to act as FIA’s Compliance Officer on a part-time
consultancy basis, with immediate effect. As part of the agreement, McGuinn is only required to go into
the office once a week, with most of the communication between him and senior management being via
e-man or over the phone as needed.
McGuinn immediately reviews a Request for Proposal (RFP) to be submitted the next day to a potential
pension fund client. The proposal is identical to another R.FP sent out two months ago and includes
FIA’s organizational structure, an in-depth description of their investment process along with the
occasional use of third-party research providers and details a guarantee of a minimum 5% investment
return and return of principal through a guaranteed structured savings product, underwritten by a life
insurance company.
That same day, Colleen Collins, a Research Analyst approaches McGuinn concerned that she may be in
possession of insider information. The analyst relates how she was at a party the night before and
overheard a conversation between two CFOs of competing publicly listed manufacturing companies. The
CEOs discussed an industry online newsletter, available by subscription only, speculating on the benefits
of a merger between their two companies. One of these companies is on F1A’s recommended buy list.
Following this conversion, McGuinn feels it necessary to enhance FIA’s rules and procedures when
dealing with possible insider information. He recommends the following changes to the companys

policies and procedures:


Recommendation 1: Stop market-making activities when in possession of material non-public
information.



Recommendation 2: Regularly review employee and proprietary trading.




Recommendation 3: Require all employees to attend an annual refresher course on how to identify
and handle material nonpublic information.

After reviewing how FIA chooses and retains its stockbrokers every year. McGuinn recommends the
following: Stockbroker selection should be based on the following guidelines:


Guideline 1: Their ability to provide administration services.



Guideline 2: Execute transactions in a timely fashion.



Guideline 3: Obtain best prices.

McGuinn undertakes an investigation based on reports citing several FIA fund managers witnessed to
have been wined and dined the past few weeks by large brokerage firms trying to get FIA’s business. The
same employees have not notified him of these dinners, violating FIAs internal policies. McGuinn
notifies the employees in writing that they have been violating the company policy. In the letter of
notification, he requires the employees to abide by the policy in the future.
1. Did Collins most likely receive insider information as defined by the CFA Standards?
A. Yes.
B. No, because the information is consideration public.
C. No, because the information is considered nonmaterial.
2. Prior to acceptance of FIA’s offer, McGuinn should most likely undertake which of the following to
avoid any violation of the CFA institute Code and Standards?
A. Because a full-time employee.
B. Assess the adequacies of existing procedures.
C. Merge compliance procedures into the firms code.
3. Which response in the Request for proposal (RFP) most likely violates Standard I(C)
Misrepresentation?
A. Guaranteed investment return.
B. Firm’s organizational structure.
C. Use of third-party research providers.
4. Which of McGuinn’s recommendation is least appropriate to implement as per recommended
procedures for compliance of Standard II(A) Material Nonpublic Information?
A. Recommendation 1.
B. Recommendation 2.
C. Recommendation 3.
5. Which Guideline regarding choosing stockbroking services most likely violates Standard III Duty to
Clients?
A. Guideline 1.
B. Guideline 2.
C. Guideline 3.

6. Regarding fund managers under investigation, the least appropriate further action McGuinn should
take is:
A. Monitor their future actions.
B. Report the misconduct up the chain of command.
C. Require a statement stating the behavior will not be repeated.


Brendan Dennehy Case Scenario
Brendan Dennehy, CFA, works for Transon Investments, Plc., a Dublin-based hedge fund with
significant equity investments in technology companies in Asia. North America and Europe. Transon is
concerned by the recent poor performance of one of the fund’s Chinese investments, Winston
Communications, an assembler of telecommunications equipment. Transon’s chief of information
technology (IT) is Sean Malloy. Yesterday, Winston’s IT office sent Malloy data relating to the assembly
process and a printout of an analysis of the number of defective assemblies per hour, Winston’s IT
people believe that the number of defective assemblies per hour is a function of the outside air
temperature and the speed (production rate) of the assembly lines. Malloy recalls that Dennehy has had
substantial training in statistics while working on his MBA. He asks Dennehy to help him interpret the
regression results supplied by Winston.
Exhibit 1
Regression Results

Dt=b0+b1Airt+b2Rt+εt
coefficient

Std. Error

Constant（b0）

0.0160

0.0942

Outside air temperature（b1）

0.0006

0.0010

Assembly line speed（b2）

0.5984

0.3000

Number of observations used in the regression

384

Critical t value at 5% significance (two-tail test that coefficient equals zero)

1.96

R square

Std. Error of the estimate

Durbin-Watson

F

Significance of F

0.414

0.333

1.890

157.699

0.000

1.63

1.72

Durbin-Watson critical values (5% significance)

Using the data provided in Exhibit 1, Dennehy tests the hypothesis that the coefficients for outside air
temperature and assembly line speed are significantly different from zero, using a significance level of
5%.
Next Dennehy would like to confirm that nonstationarity is not a problem. To test for this he conducts
Dickey-Fuller tests for a unit root on each of the time series. The results are reported in Exhibit 2.
Exhibit 2 Results of the Dickey-Fuller tests
Time series

Value of the test statistic

Std. Error

t

Significance of t

0.0036

0.0023

1.591

0.1123

Outside air temperature

-0.423

0.0724

-5.846

0.000

Assembly line speed

-0.586

0.043

-13.510

0.000

Defective

assemblies

per

hour

Dennehy tells Malloy about the Dickey-Fuller test results, stating:
We can safely use regression to estimate the relationship between the dependent variable and the
independent variables if:


1.

none of the three time series exhibit a unit root, or

2.

all three series exhibit a unit root but they are also mutually cointegrated.

Malloy disagrees in part with Dennehy’s statement, He agrees with Dennehy about the use of regression
if none of the time series exhibit a unit root. But Malloy believes that it is safe to estimate the regression
if only the independent variables exhibit unit roots but are cointegrated, and the dependent variable
does not exhibit a unit root.
7. Based on Exhibit 1, Dennehy’s tests of the two regression coefficients show a significant different from
zero for the coefficient(s) for:

A. Assembly line speed （b2） only.
B. Outside air temperature （b1）only.
C. Both outside air temperature （b1）and assembly line speed（b2）.
8. The results reported in Exhibit 1 suggest:
A. The F-statistic of the regression is not significant.
B. Predictions of defective assemblies per hour made using the regression have only about a 41% chance
of being correct.
C. Variations in the independent variables explain appropriately 41% of the variation in the defective
assemblies per hour.
9. What is the most appropriate inference from the Durbin-Watson statistic reported in Exhibit 1? The
Durbin-Watson test:
A. Is inconclusive.
B. Rejects the null hypothesis of no positive serial correction.
C. Fails to reject the null hypothesis of no positive serial correction.
10. Assuming a 5%level of significance, the Dickey-Fuller results reported in Exhibit 2 show that the:
A. Test for a unit root is inconclusive for the dependent variable.
B. Dependent variable exhibits a unit root but the independent variables do not.
C. Independent variable exhibits a unit root but the dependent variables do not.
11. Dennehys statement about the Dickey-Fuller test is best characterized as:
A. Correct.
B. Incorrect, because only the dependent variable series needs to be tested for the absence of a unit root.
C. Incorrect, because only the independent variable series needs to be tested for the absence of a unit
root.
12. Malloy’s reply to Dennehy about the Dickey-Fuller test is best characterized as:
A. Correct.
B. Incorrect because the regression results are valid whether a unit root exists or does not exist for the
dependent variable when the independent variables are cointegrated.
C. Incorrect because if any of the time series have unit roots, all of the time series must have unit roots
and must exhibit mutual cointegration for the results of the regression to be valid.

Nation Resorts Ltd. Case Scenario
Nation Resorts Ltd (Nation) is a U.S,-based operator of destination vacation resorts, Resorts are divided
into three types: Winter, which are located at ski mountains; Golf, located on championship courses in
locations such as Arizona; and Seaside located at beaches with ocean, and other activities available, The
three types of resorts generally attract different types of vacationers, and provide different vacation
packages for different vacation budgets, Although the Winter and Golf resorts are somewhat
counter-seasonal, the company still suffers from the risk of the U,S, economy as well as the risk of
unfavorable local weather conditions (lack of snow or sun), To diversify and reduce these risks, Nation
started purchasing properties in other geographic areas including Europe and Central America.
Nation made its first foreign investment when it bought a resort in Jamaica on 1 May 2008, Initially
Nation provided managers to assist in operating the resort but then hired local Jamaicans into their
management development program, and one was recently appointed to a senior position at the resort,
Nation invested in building and up grading facilities with the initial expansion financing provided by
Nation’s U,S, bank, Concerned about the high rate of inflation in Jamaica which at the time of purchase
had averaged 20% per annum over the previous three years, Nation kept excess funds in US, dollars,
Vacation packages are sold primarily in the United States and prices reflect competitive conditions in the
U,S, vacation market. The resort uses local labor and supplies and is expected to be profitable for the
first time this year. Inflation has now declined to 14% per annum, Nation expects to be able to reinvest
any profits in the resort and start using a local bank for ongoing financing needs.
On I July 2010 Nation acquired its first European resort, Val Blanc SA, a ski resort in the Alps region of
France, Nation paid €28 million for 100% of the company, The resort attracts skiers primarily from
France and other European countries, The transition has gone very well with Nation leaving the local
managers in place to make all operating and financial decisions, To date the only financial contribution
by Nation has been the initial equity investment, Financial statements for the ski resort at acquisition
and for the six months since then are shown in Exhibit 1.
Financial Statements (all figures in thousands)
Income Statement
31 Dec 2010

30 June 2010

6 months

12 months

Resort revenues

€ 12,025

€ 46,805

Operating expenses

9,800

35,105

Depreciation and amortization

1,750

4,000

interest expense

1,200

2,500

Earnings before taxes

€(725)

€5,200

income taxes

0.00

1,300

Net earnings

€(725)

€3,900

Statement of Financial Position
Cash and marketable securities

31 Dec 2010

30 June 2010(1)

€5,750

€5,000

Account receivable

6,500

3,000

Inventory

8,000(2)

5,000

Total current assets

€20,250

€13,000

Property, plant and equipment

41,750

43,500

Intangible asset5

5,000

5,000

Total assets

€67,000

€61,500

Current liabilities

€12,225

€5,000

Long-term debt

26,000

27,000

Share capital

20,000

20,000

Retained earnings

8,775

9,500

Total liabilities and equity

€67,000

€61,500

(1)The

30 June 2010 Statement of Financial Position reflects the fair value of the identifiable assets and

liabilities of Val Blanc at acquisition.
(2) 31

December 2010 inventory was acquired evenly throughout the period since acquisition.

Paul Nakiska, a business analyst with Nation, is meeting with Nation’s Manager of Financial Reporting.
Max Chara, to discuss how the company should account for the two foreign resorts in the 2010 financial
statements, and the impact the resorts will have on Nation’s reported results. Nation has a 3 1 December
yearend and prepares its financial statements according to U.S. GAAP.
In preparation for the meeting, Nakiska’s first task was to prepare the purchase price allocation of the
Val Blanc acquisition using the acquisition method. He has also gathered some exchange rate
information related to the two resorts, Exhibit 2.
Exhibit 2 Selected Exchange Rates
Date

$US = $1 JMD

$US = 1€

1 May 2008

0.0139

N/A

l January 2010

0.0115

1.4368

30 June 2010

0.0117

1.2250

31 December2010

0.0117

1.3261

Average 2010

0.0115

1.3277

Average January — July 2010

0.0113

1.3303

Average July — December 2010

0.0117

1.3198

Nakiska started the meeting:
I suggest we use the current rate method for both of our foreign subsidiaries because that will simplify
our financial reporting. The current rate method also allows the key metrics we use to valuate
performance; the current ratio, fixed asset turnover and operating margin, to be the same after
translation as before.
Chara replied:


I am not so concerned about the translated metrics, because we evaluate the performance of each resort
in its local currency; however, I am concerned about the effect on Nation’s consolidated net income and
return on equity.
If we use the temporal method for the resort in France, we can take advantage of the strengthening Euro
and report the translation gain on the income statement.
I am also not so concerned about using the same method for all subsidiaries, if using different methods
will help increase our net income.
Nakiska agreed to calculate the effects of the various translation methods and of the Val Blanc
acquisition on the financial statements and send the report to Chara.
13. In 2008 Nation most likely used which of the following translation methods for the Jamaican resort?
The:

A. temporal method, due to the high rate of inflation.
B. temporal method, because the US dollar was the functional currency.
C. current rate method, because the Jamaican dollar was the functional currency.
14. Nakiska’s allocation of the purchase price of the acquisition of Val Blanc will most likely result in
which of the following for Nation, in €, before translation of the subsidiary’s financial statements?
A. Again of 1,500.
B. Goodwill of 8,000.
C. An increase in retained earnings of 9,500.
15. The net income (in $ US) from the Val Blanc subsidiary that will be included in Nations income for
2010 is closet to:
A. (791).
B. (957),
C. (961).
16. Using the translation method suggested by Nakiska, the total shareholders’ equity of the Val Blanc
resort on 31 December 2010 after translation is closet to:
A. $ 32,203.
B. $35,181.
C. $38,159.
17. Nakiska’s comment about the key performance metrics is least accurate with respect to:
A. Current ratio.
B. Operating margin.
C. Fixed asset turnover.
18. Is Chara correct in his assessment of the effect of using the temporal method on the Val Blanc resort?
A. No ,because it would result in a translation loss on the income statement.
B. Yes, because it would result in a translation gain on the income statement.
C. No, because the translation gain or loss would not be reported in net income.


Fargo Durum Farms (FDF) Case Scenario
Minneapolis Viking Arbitrageurs, LLC (MVA), is a fledgling U.S-based hedge fund having slightly over $

50 million under its management. MVA specializes in owning and managing small-sized properties in
agriculture, forestry, and mining. Its average investment is about $8 million.
Jim Hester, MVA’s Managing Partner and Chief Investment Strategist is examining the financial
statements and other pertinent information about Fargo Durum Farms, Inc. (FDF), as a potential
investment opportunity.
FDF is jointly owned by two brothers, John and Man, of the Mahoney family. With all their children
graduated from North Dakota State University and currently living in Minneapolis, the brothers have
decided to sell the property. Hester believes that commodity prices will continue their uptrend for
extended periods and investing in a North Dakota farming operation where farm lands are still
attractively priced will produce high returns for the hedge fund. Its tangible assets including working
capital comprise approximately 1,500 acres of fertile and well-irrigated land, farm buildings, machinery,
residential quarters, livestock, cattle feed, seeds, gain, and so forth. FDF also carries significant
intangible assets that include biological assets, patented hybrid seeds, and milk quotas.
Select data from FDF’s income statement for the year ended December 2010 are presented in Exhibit 1.
Exhibit 2 contains additional estimates compiled by Hester.
Exhibit 1

FDF’s Selected Financial Data for the year ended December 2010

Gross Revenues from crops, livestock, feed, etc.

$2,500,000

Cost of goods sold

1,000,000

Selling, general, and administrative expenses (SG&A)

900,000

Depreciation and amortization

200,000

Tax rate

30%

Notes:
i) FDF carries debt in the amount of $750,000 at an interest rate of 8%, and it comprises 30% of total
assets on book value basis. Debt will be a part of the acquisition transaction.
ii) FDF holds $200,000 in cash and short-term investments, but it will not be a part of the assets under
acquisition transaction.
Exhibit 2 Additional data and Hester’s estimates for normalization
1

The cost of goods sold ratio should be higher at 45%.

2

SG&.A includes 5400,000 in owners’ compensation. According to Hester’s research, owners’
compensation expense for similar sized farms is 5200,000.

3

A ranch and living quarters are not required for the farm’s core operations, A total of
5125,000 in expenses (525,000 in depreciation and 5100,000 in operating expenses included in
SG&A) relate to those properties. The ranch and living quarters will be kept by the current owners
and are not a part of FDFs farming operations being considered for purchase by the hedge fund.

4

For pro forma purposes, depreciation and amortization will be 10% of gross revenues and the


current tax rate of 30% is considered reasonable.
First, Hester assesses FDFs normalized operating income after tax. Next, he values FDF’s equity using
the free cash flow to the firm (FCFF) approach under the following additional assumptions.


Revenues and free cash flows will grow at a constant rate of 5% per year for the foreseeable future



On average, FDF’s operating income (EBITDA) will be 30% of gross revenues



Required capital expenditures will equal the projected depreciation & amortization expense plus
10% of the incremental revenue



Additional working capital (other than cash) equal to l5°/ of the incremental revenue is required



The cost of equity and weighted average cost of capital (WACC) are 14% and 11.5%, respectively

Hester presents his initial assessment and valuation of FOF to MVA’s Investment Committee, The
comments and suggestions from some members on the Committee are as follows:
Xavier Moreno, Commodities Analyst, suggests the use of excess earnings method (EEM) for valuing
FDF and makes the following three statements in support of his preference:
1. EEM involves estimating the earnings remaining before deducting amounts that reflect the required
returns to the tangible assets.
2. It is a widely used method for pricing entire private businesses such as FDF.
3. EEM is especially useful for valuing FDF as it allows for valuing working capital, fixed assets, and
intangibles using different discount rates.
Jamal Bahrami, the External Consultant on the Committee differs from Hester and prefers the use of
free cash flow to equity (FCFE) model. Further, he develops his own estimates for valuing FDF’s equity.


Owing to the continued strength in the global demand for wheat, FDF will experience a higher
annual growth rate of 10% over the next two years, 2011 and 2012; thereafter, it will grow at a
constant rate of 6% per year.



Next year (201 1)FDF will realize $1,000,000 in cash flow from operations



To support its high growth needs, FDF will require $400, 000 in new capital investment next year



The company would need additional borrowing in the amount of $250,000 at an interest cost of
8%



Because of illiquidity and small-firm risk premiums. the appropriate WACC and required return on
equity respectively, will be higher at 12.9% and 16%

Hester made a cash offer of $ 9 million to the Mahoney brothers, However, they decided to make a
counteroffer and approached Joselyn Olsen, a reputable agriculture industry analyst at the Red River
Valley Consultants, LLP, for her assessment of FDF’s value.
Olsen prefers the guideline transactions method (GTM) using next year’s expected EBITDA to value FDF
and she estimates the following from the company data, market information, and her own assessments.


FDF’s expected 2011 gross revenue = $ 2,800,000



2011 cost of goods sold =42% of gross revenue



2011 SG&A = 25% of gross revenue




Three recent purchase transactions of similar farms in North Dakota indicate an average MVIC
(Market Value of Invested Capital) to EBITDA multiple of 9.0.



FDF commands a 30% control premium.



FDF need not incur any additional capital expenditures or borrowing

Olsen justifies her choice of the GTM approach in the following three statements:
1. The GTM approach works well for valuing FDF as it uses a multiple that specially relates to sales of
entire companies. SFAS No.157 presents a fair value hierarchy that gives the highest priority to market
based evidence. Further, tax courts in U.S. assessing private company valuations have generally stated a
preference for valuation based on market transactions.
2. Most appraisers readily accept the valuation from GTM approach because of the reliability of
transactions data.
3. The market approach to determine the value of equity is appropriate even for companies with highly
leveraged financial conditions or significant volatility expected future financial performance.
Satisfied with Olsen’s valuation and her methodological choice, the Mahoney brothers move ahead with
their counteroffer to Hester.
19. The normalized operating income after taxes for the year 2010 for FDF using the company’s data and
Hester’s assessments and estimates in Exhibits 1 and 2 is closet to:
A. $ 325,500.
B. $367,50ft
C. $402,500.
20. FDF’s value of equity as at the end of 2010 using the company data in Exhibits 1, and Hester’s
approach and assumptions, is closet to:
A. $5,611,111.
B. $ 8,084,877.
C. $8,526,620.
21. In regard to Morenos three statements, he is most accurate with respect to the statement:
A. 1.
B.2.

C.3.
22. The value of FDFs equity as of December 31,201U, according to the approach preferred by Bahrarni
and using the estimates developed by him is closet to:
A. $8,554,891.
B. $8,793,104.
C. $ 12,755,292.
23. The value of FDFs equity as at the end of 2010 according to the approach and estimates by Olsen is
closet to:
A. $ 10,060,800.


B. $ 10,260,800.
C. $10,810,800.
24. Which of Olsen’s three statements justifying her choice of GTM approach is most accurate?
A. Statement 1.
B. Statement 2.
C. Statement 3.


Martin Investment Management Inc Case Scenario
Jennifer Martin, CFA, is the owner of Martin Investment Management mc, a boutique company that
specializes in managing money for high-net-worth individuals. The firm specializes in real estate and
private equity investments, Martin has three client meetings today.
The first meeting is with Larry Smith, Smith is interested in investing in real estate but is not sure what
type of real estate would be most appropriate for him, Smith is an executive with a major management
consulting firm. He has a high income, so his main goal is to use real estate investments as a tax shelter.
Martin uses the internal rate of return (IRR) method to evaluate real estate investments. She is aware of
problems with this method, and makes the following statement to Smith:
“Using the IRR method can be problematic. For example if project cash flows change from positive to
negative, you can end up with more than one IRR. You can also end up ranking projects incorrectly

using the IRR method if they are substantially different in size.”
Martins second meeting is with Andre Metcalfe, Metcalfe is interested in investing in apartment
buildings, Martin tells Metcalfe about three apartment buildings that may be suitable, The details are
shown in Exhibit 1.
Exhibit 1 Apartment Buildings-selected Information
Apartment 1

Apartment 2

Apartment 3

Net Operating Income

$80,000

$95,000

$88,000

Depreciation

$7,000

$9,000

$8,000

Annual Debt Service

$25,000

$26,000

$24,000

Interest Paid

$22,000

$21,000

$20,000

Tax Rate

35%

35%

35%

Discount Rate

13%

11%

9%

Capitalization Rate

14%

9%

11%

Metcalfe also tells Martin that he is a very conservative investor and, if he invests in real estate his main
goal is to invest in a property that is likely to appreciate in value.
Martin’s third meeting is with James Wolfe, who is interested in investing in venture capital or private
equity funds. He is financially very comfortable and is therefore willing to take on risk. Martin has
recently received some information about a new venture capital deal involving a software company that
may be of interest to Wolfe as he used to be an executive in the software industry. Information about the
software company for the venture capital deal is provided in Exhibit 2.
Exhibit 2

Venture Capital Deal — Investment Information

Terminal value (at time of exit)

$1,000,000

Time to exit event

3 years

Amount of investment

$200,000

Discount rate used by investor

40%


Wolfe is also interested in investing in private equity funds, but is not familiar with how their
management compensation systems work. He wants to make sure that management stays motivated and
is focused on maximizing profits. Martin tells Wolfe that most private equity funds have a mechanism in
place that enables the management team to increase its equity allocation depending on the companys’
actual performance and the return achieved by the private equity firm.
25. Given Smith’s real estate investment goal, the least suitable investment for him is:
A. an office building.
B. vacant or raw land.
C. an apartment building.
26. Martin’s statement to Smith concerning the internal rate of return analysis method is most likely
A. correct.
B. incorrect about the size of projects.
C. incorrect about the change in the sign of cash flows.
27. Based on the information in Exhibit 1, the after-tax cash flow for Apartment 1 is closet to:
A. $37,150.
B. $38,200.
C. $40,150.
28. Based on the information in Exhibit I and Metcalfe’s main goal for real estate investing, he should
most likely invest in:
A. Apartment 1.
B. Apartment 2.
C. Apartment 3.
29. Based on the information in Exhibit 2, what is the pre-money valuation of the venture capital deal?
A. $164,431.
B. $291,545.

C. $364,431.
30. In his discussion with Wolfe on private equity funds, the mechanism Martin mentions is most likely
a:
A. ratchet.
B. clawback provision.
C. distribution waterfall.


Aubrey Yacht Manufacturers Case Scenario
Jack Aubrey and his brother Charles are co-founders of Aubrey Yacht Manufacturers of Miami, Florida,
The company specializes in the production of yachts in the $ 200,000 to $ 800,000 price range, The
Aubrey brothers took the company public in 1998 and its shares are now traded on NASDAQ under the
symbol AYM.
Jack is the President and Charles is the CEO and Chairman of the Board, The demand for yachts in
AYM’s price range had been quite strong going into the recent recession, which began at the end of 2007,
Unfortunately, production at AYM had been curtailed during that time because of a strike that had
started in early June of that year, The company had been able to reduce its finished goods inventory
substantially by the time the strike ended in January 2008, Throughout 2008, the company carried little
inventory and reduced its debt from its long run average of 25% debt to equity, Finally in 2009, it repaid
all of its outstanding debt, The result was that the company emerged from the recession much stronger
than other yacht manufacturers.
Earnings and dividends had been growing strongly until the strike occurred. The company paid its first
dividend in 2002 but discontinued it soon after the strike began. Exhibit I shows the history of the
company’s earnings per share (EPS) and dividends per share (DPS) since 2002.
Exhibit 1 Aubrey Yacht Manufacturers Earnings and Dividend history for years ending
31 December 2002—2011
Year

EPS ($)

DPS ($)

2002

4.18

2.17

2003

4.34

2.26

2004

4.52

2.31

2005

4.77

2.48

2006

5.05

2.58

2007

5.18

2.64

2008

2.60

2009

2.40

2010

4.80

2011

5.50

In 2011, sales of yachts in the company’s price range seemed to have recovered more than the super
yacht category (priced from $ 2 to $40 million), Jack Aubrey’s forecast is for earnings in 2012 to be $
6.60 per share, and he is confident that a dividend of $ 3,42 per share could be reinstated at that time,
however, he also wants to ensure that future dividends would not be cut as had been done in 2008,
Commencing in 2013 he plans on establishing a stable dividend policy with a long-term target payout
ratio of 35% with an adjustment factor of 0.20; i.e., the adjustment is to occur over a 5-year period, He

estimates that earnings in 2013 would be $8.05 per share.


Steve Maturin is a director of AYIVI and has been a close friend of Charles since childhood, Maturin is
the CEO of Standard Marine Containers, a manufacturer of plastic pallets and crates used in marine
shipping, Jack Aubrey is a director of Standard Marine Containers.
Charles, Maturin and their families had just returned from a two-week cruise to Bermuda on the
company’s best yacht, Maturin informed lack that the weather on this year’s trip was much better than
last year, that he was well rested and ready to tackle some thorny issues in their first board meeting of
the year, “In particular, “ said Maturin, “alternatives to paying dividends, moving to a staggered board of
directors, and the company’s financing mix are items of great interest to me.”
Maturin reminded Aubrey that the results of a survey that had been conducted last year on a large
sample of the company’s investors indicated that on average the investors tax rate on capital gains was
23%, but their tax rates on dividends varied widely across the sample, Maturin also said that on
reviewing the company’s share price behavior during the 2002 to 2007 period, he found that it normally
fell on average by about 68% of the dividend amount when the shares went ex’-dividend.
Maturin said: “I’ve been thinking that our current annual election of the board is not in the best interests
of our shareholders, and we should be moving to a staggered board for the following reasons:
1. the company would be less likely to resist hostile takeover attempts with a staggered board.
2. it would ensure the continuity of the knowledge and experience in the company that is so essential for
good corporate governance, and,
3. it would provide board members more time in getting to understand the needs of shareholders and be
in a better position to align their interests with them.”
Exhibit 2 shows selected information about the company’s current Board of Directors taken from its
website and regulatory filings.
Exhibit 2

Aubrey Yacht Manufacturers Composition of the Board of Directors. 2011

Director

Director Status

Director Since

Current Position

Charles Aubrey

Executive

1998

CEO.AYM. Chairman of the Board

Jack Aubrey

Executive

1998

President, AVM

Bill Babbington

Independent

2000

Dean of Engineering, Florida Maritime

College

Molly Harte

Independent

2000

Director

of

Equity

Research,

First

Marine Bank of Miami
Steve Metunrin

Independent

1998

CEO. Standard Marine Containers

Thomas Pullings

Independent

2010

Retired

managing

partner,

Price,

Lybrand and Waterways, LIP
Sophie Williams

Independent

1998

Professor and Chairman, Grand Banks
Nautical

Industrial

Institute

Technology
Among the directors, only the Aubreys have ever had an employment relationship with the company.

of

Maturin concluded his remarks by saying, “I would like to see the company use debt again, It should
issue debt and repurchase shares to return to its historical level 0.25 debt-to-equity. We should be able
to issue debt at a cost of 5%, and this should not materially increase the costs of financial distress,
agency costs, or asymmetric information. With our current cost of equity at 12% and a 30% tax rate, our
weighted average cost of capital should drop, enhancing shareholder value.”
31. The dividend policy that was used by Aubrey Yacht until the strike occurred is best described as a:
A. stable dividend policy.
B. residual dividend policy.
C. constant dividend payout ratio policy.
32. If Aubrey’s earnings and dividend estimates for 2012 and 2013 are correct, and the company adopts
his suggested dividend policy, the company’s 2013 dividends per share will be closed to:
A. $3.49.
B. $3.52.
C. $4.17.
33. If the results of the survey mentioned by Maturin is representative for all of the firm’s investors, and
applies as well to the 2002 to 2007 period, the marginal tax rate on dividend income applying to those
who trade the company’s shares around the ex-dividend date is closed to:
A. 15.6%.
B. 32.0%.
C. 47.6%.
34. Which of Maturin’s reasons for adopting a staggered board is most consistent with best practices of
corporate governance?
A. 1.
B.2.
C.3.
35. Which of the following factors best supports Maturin’s classification as an independent director of
AYM?
A. Maturin’s employment history with the company.
B. Personal relationships between Maturin and Charles.

C. Jack’s membership on the board of Standard Maturin Containers.
36. Using Maturin’s assumptions, the company’s weighted average cost of capital under his proposed
financing plan would be closet to:
A. 9.8%.
B. 10.3%.
C. 11.3%.


Level II Version 1_v10 2012 Sample Exam
Click here to to go to MyCFA.

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level II, Vol. 1, pp. 101-103
Study Session 1-2-b
Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.
1

2

B is correct. McGuinn should make an assessment on whether he would be able to clearly discharge
his supervisory responsibilities as a Compliance Officer before accepting the offer. FIA’s adoption of
the CFA Institute Code and Standards does not necessarily imply they have in place proper policies and
procedures to ensure compliance with the Code and Standards. Especially since the adoption occurred
ten years ago and it was at that time an assessment of the adequacy of the policies and procedures was
last made According to Standard IV (C) Responsibilities of Supervisors, in the absence of a compliance
system or an inadequate one, a member should not accept supervisory responsibility until such time that
the firm adopts reasonable procedures to allow adequate exercise of supervisory responsibilities.

“Guidance for Standards I-VII,” CFA Institute

2012 Modular Level II, Vol. 1, pp. 38-40
Study Session 1-2-a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations.
B is correct. The RFP was done on the basis of the old organizational structure. Standard I (C) requires
members not to misrepresent the qualifications of a firm. With a senior professional leaving the firm,
the organizational structure should have been updated prior to submitting an RFP for a potential client’s
consideration.

3

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level II, Vol. 1, pp. 49-51
Study Session 1-2-a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations.
C is correct. When determining whether information is considered “insider,” the source of the
information must be assessed. An industry or trade newsletter that speculates on the benefits of a merger
between two companies does not necessarily mean the two companies are actually merging. The two
CEOs are overheard discussing the newsletter but never provide their perspectives on the article, so the
information is related only to the newsletter. Hence the information would not be considered material.


4

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level II, Vol. 1, pp. 52-55
Study Session 1-2-b
Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.

A is correct. When a firm acts as a market maker, a prohibition on proprietary trading may be
counterproductive to the goals of maintaining the confidentiality of information and market liquidity.
In some cases a withdrawal by the firm from market-making activities would be a clear tip to outsiders.
Firms that continue market-making activity while in the possession of material nonpublic information
should, however, instruct their market makers to remain passive to the market: i.e., take only the contra
side of unsolicited customer trades.

5

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level II, Vol. 1, p. 66
Study Session 1-2-a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations.
A is correct. Standard III (A) Loyalty, Prudence, and Care requires an investment manager to use client
brokerage to the benefit of the client and not the firm. When members or candidates use client brokerage
to purchase goods or services that do not benefit the client (“soft dollars” or “soft commissions”), such
as administration services, a disclosure regarding how the firm addresses the potential conflict of interest
must be made to the client.

6

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level II, Vol. 1, pp. 101-102
Study Session 1-2-b
Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.
C is correct. As a supervisor (Standard IV (C) Responsibilities of Supervisors), McGuinn has the
responsibility after he notices and investigates the violation to report the violation up the chain of
command as well as to monitor the employee to ensure the errant behavior has changed and conforms

to the Code and Standards. A statement from the errant employees stating they will cease the activity in
violation is not enough.


7

“Correlation and Regression,” Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto,
CFA, and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, pp. 311-317
“Multiple Regression and Issues in Regression Analysis,” Richard A. Defusco, CFA, Dennis W.
McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, p. 355
Study Sessions 3-11-e, g; 3-12-b
Explain the assumptions underlying linear regression, and interpret the regression coefficients. 
Formulate a null and alternative hypothesis about a population value of a regression coefficient, select
the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of
significance.
Formulate a null and an alternative hypothesis about the population value of a regression coefficient,
calculate the value of the test statistic, determine whether to reject the null hypothesis at a given level of
significance by using a one-tailed or two-tailed test, and interpret the results of the test.
The null hypotheses are that the coefficients equal zero. The alternative hypotheses are that the
coefficients do not equal zero (two-tailed tests). The appropriate test statistics, t, are calculated by
dividing the estimates of the coefficients by their respective standard error. 
             tb1 = 0.0006 / 0.0010 = 0.60
              tb2 = 0.5984 / 0.30 = 1.9947
The test statistic for outside air temperature is less than the critical value of 1.96. The test statistic
for assembly line speed exceeds the critical value of 1.96. We cannot reject the null hypothesis that
the population regression coefficient for outside air temperature, b1, is zero. We can reject the null
hypothesis that b2 is zero at the 5% level of significance.

8

“Correlation and Regression,” Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto,
CFA, and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, pp. 308-310, 319-322
“Multiple Regression and Issues in Regression Analysis,” Richard A. Defusco, CFA, Dennis W.
McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, pp. 363-366
Study Sessions 3-11-f, I; 3-12-g
Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence
interval for a regression coefficient. 
Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and
calculate and interpret an F-statistic. 
Evaluate how well a regression model explains the dependent variable by analyzing the output of the
regression equation and an ANOVA table.
The R2 indicates that variations in the independent variables explain approximately 41% of the variation
in the dependent variable. The F-statistic is highly significant. R2 does not inform us regarding the
probability of a dependent variable prediction being correct.


9

“Multiple Regression and Issues in Regression Analysis,” Richard A. Defusco, CFA, Dennis W.
McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, pp. 379-381
Study Session 3-12-i
Explain the types of heteroskedasticity and the effects of heteroskedasticity and serial correlation on
statistical inference. 
The value of the Durbin-Watson statistic is given in Exhibit 1 as 1.890. The critical values are given as
1.63 and 1.72. As the value (1.89) exceeds the upper critical value (1.72), the D-W test fails to reject the

null hypothesis of no positive serial correlation.

“Time-Series Analysis,” Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA,
and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, p. 469
Study Session 3-13-c, j, k, n
Explain the requirement for a time series to be covariance stationary, and describe the significance of a
series that is not stationary.
Describe implications of unit roots for time-series analysis, explain when unit roots are likely to occur
and how to test for them, and demonstrate how a time series with a unit root can be transformed so it can
be analyzed with an AR model.
Describe the steps of the unit root test for nonstationarity, and explain the relation of the test to
autoregressive time-series models.
10 Explain how time-series variables should be analyzed for nonstationarity and/or cointegration before use
in a linear regression.
The Dickey-Fuller test uses a regression of the type: 
xt – xt–1 = b0 + g1xt–1 + εt , E(εt) = 0 
The null hypothesis is H0: g1 = 0 versus the alternative hypothesis H1: g1 < 0 (a one-tail test). If g1= 0 the
time series has a unit root and is nonstationary. Thus, if we fail to reject the null hypothesis, we accept
the possibility that the time series has a unit root and is nonstationary.
Based on the t ratios and their significance levels in Exhibit 2, we reject the null hypothesis that the
coefficient is zero for both outside air temperature and assembly line speed (i.e., the independent
variables). We do not reject the null for the dependent variable, defective assemblies per hour.


“Time-Series Analysis,” Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA,
and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, pp. 490-491
Study Session 3-13-n
Explain how time series variables should be analyzed for nonstationarity and/or cointegration before use

in a linear regression. 
11

One possibility is that none of the time series used in a regression exhibit a unit root. In that case, we can
safely use regression analysis. Alternatively, as noted on p. 491 of the reading:
“If at least one time series (the dependent variable or one of the independent variables) has a unit root
while at least one time series (the dependent variable or one of the independent variables) does not, the
error term in the regression cannot be covariance stationary. Consequently, we should not use multiple
linear regression to analyze the relation among the time series in this scenario.
Another possibility is that each time series, including the dependent variable and each of the
independent variables, has a unit root. If this is the case, we need to establish whether the time series are
cointegrated.”
When all series used in a regression display unit roots, but they are also mutually cointegrated, we can
safely use regression analysis.

“Time-Series Analysis,” Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA,
and David E. Runkle, CFA
2012 Modular Level II, Vol. 1, pp. 487-491, 495
12 Study Session 3-13-n
Explain how time series variables should be analyzed for nonstationarity and/or cointegration before use
in a linear regression. 
If any of the time series used in a regression exhibit a unit root, all of the time series must have unit roots
and they must exhibit mutual cointegration for the results of the regression to be valid.

13

“Multinational Operations,” Timothy S. Doupnik
2012 Modular Level II, Vol. 2, pp. 272-274, 278
Study Session 6-24-a, f 
Distinguish among presentation currency, functional currency, and local currency.

Analyze the effect of alternative translation methods for subsidiaries operating in hyperinflationary
economies.
Based on the facts described, the U.S. dollar was the functional currency of the resort in 2008. The
U.S. economy and the U.S. dollar are the factors that influence the prices of the vacation packages. The
operations were financed from the United States and excess funds were also invested there. Nation also
supplied onsite management. Therefore, the temporal method would be the most appropriate method to
use. Although inflation was high at 20% per year over the past three years, that would not meet FASB’s
definition of hyperinflation, which requires the temporal method be used for subsidiaries normally using
the current rate method.


“Intercorporate Investments,” Susan Perry Williams 
2012 Modular Level II, Vol. 2, pp. 149-150
Study Session 6-22-a, c
Describe the classification, measurement, and disclosure under International Financial Reporting
Standards (IFRS) for: (1) investments in financial assets, (2) investments in associates, (3) joint ventures,
(4) business combinations, and (5) special purpose and variable interest entities.
Analyze effects on financial statements and ratios of different methods used to account for intercorporate
14 investments.
The acquisition was a bargain purchase for Nation:
Price paid
Fair value of the net assets (Exhibit 1)
Share capital + retained earnings = 20,000 + 9,500
Negative goodwill
Negative goodwill is recognized immediately as a gain in profit or loss.

€28,000
29,500
€ (1,500)

“Multinational Operations,” Timothy S. Doupnik
2012 Modular Level II, Vol. 2, pp. 275, 277, 280-283
Study Session 6-24-c, d
Compare and contrast the current rate method and the temporal method, evaluate the effects of each on
the parent company’s balance sheet and income statement, and determine which method is appropriate in
various scenarios.
15 Calculate the translation effects, evaluate the translation of a subsidiary’s balance sheet and income
statement into the parent company’s currency, and analyze the different effects of the current rate
method and the temporal method on the subsidiary’s financial ratios.
The functional currency for the Val Blanc subsidiary is the Euro; it operates independently and attracts
European tourists, and the prices are set in Euros. It is also financed in Euros. Therefore the financial
statements would be translated using the current rate method. Under the current rate method, the net
earnings (loss) is calculated using the average rate for the period (from July – December). (€725) ×
$1.3198 / 1 € = ($957)


“Multinational Operations,” Timothy S. Doupnik
2012 Modular Level II, Vol. 2, pp. 274, 276-277, 282-283
Study Session 6-24-d
Calculate the translation effects, evaluate the translation of a subsidiary’s balance sheet and income
statement into the parent company’s currency, and analyze the different effects of the current rate
method and the temporal method on the subsidiary’s financial ratios.
Total shareholders’ equity as at 31 December 2010 consists of Share capital, Retained earnings, and the
Cumulative foreign exchange gain or loss since acquisition. The total amount can be calculated either
as the sum of the individual components or as the difference between assets and liabilities. Using the
current rate method, all assets and liabilities are translated at the closing rate.
Using the difference between assets and liabilities:

16

Cash and marketable securities
Accounts receivable
Inventory
Total current assets
Property, plant and equipment
Intangible assets
Total assets

€
5,750
6,500
8,000
20,250
41,750
5,000
67,000

Current Liabilities
Long-term debt
Share capital
Retained earnings
Total liabilities and equity

12,225
26,000
20,000
8,775
67,000

Rate

$
1.3261
1.3261
1.3261

7,625
8,620
10,609

1.3261
1.3261

55,365
6,631
88,849

1.3261
1.3261

16,211
34,479
50,690
38,159

Total liabilities
Net assets

Alternatively: 1.3261 x [67,000 – (12,225 + 26,000)] = 38,159

Using the translation of individual items and calculation of the foreign exchange gain:
Share capital
Retained earnings – opening
Net earnings (loss) for the period
Foreign translation adjustment (2)
Total Shareholders’ equity

Euros
20,000
9500
(725)

Rate (1)

US $

1.225
1.225
1.3198

24,500
11,638
(957)
2,978
38,159

(1) In the current rate method the share capital and opening retained earnings use the rate at the
date of acquisition (1 July) and the change in retained earnings is equal to the net earnings (loss)
for the period at the average rate (July – Dec).
(2) Foreign Translation gain/loss calculation:

Opening net asset position
Net loss
Closing net asset position
Actual net asset position
(gain) loss

Euros
29,500
(725)
28,775
28,775

Rate
1.225
1.3198
1.3261

$
36,138
(957)
35,181
38,159
(2,978)


“Multinational Operations,” Timothy S. Doupnik
2012 Modular Level II, Vol. 2, pp. 277, 284-286
Study Session 6-24-d
Calculate the translation effects, evaluate the translation of a subsidiary’s balance sheet and income

statement into the parent company’s currency, and analyze the different effects of the current rate
method and the temporal method on the subsidiary’s financial ratios.
Ratios
Income statement
17
Balance sheet
With both income
statement & balance
sheet items

Effects
Under the current rate method all revenues and expenses are
translated at the average rate for the year; therefore, ratios involving
only income statement numbers, like the operating margin, will be
unaffected by translation.
All assets and liabilities are translated at the closing rate. Therefore,
all ratios involving only asset and liability numbers, like the current
ratio, will also be unaffected by translation.
Since the two financial statements are translated at different rates,
the fixed asset turnover ratio, (sales ÷ fixed assets), is unlikely
to provide the same result before and after translation, unless by
chance the average rate happens to equal the closing rate.

“Multinational Operations,” Timothy S. Doupnik
2012 Modular Level II, Vol. 2, pp. 270-271
Study Session 6-24-c, e
Compare and contrast the current rate method and the temporal method, evaluate the effects of each on
the parent company’s balance sheet and income statement, and determine which method is appropriate in
various scenarios.
18

Analyze the effect on a parent company’s financial ratios of the currency translation method used.
The euro strengthened against the U.S. dollar in the July – December period (1.225 to 1.3261). Under
the temporal method the exposure is limited to monetary assets less monetary liabilities, which normally
results in a net liability position (and does for the Val Blanc subsidiary). When the foreign currency
strengthens, a net liability position results in a negative translation adjustment (loss). Hence use of the
temporal method would result in a translation loss being reported on the income statement and Chara’s
statement in incorrect.