*** Level I
Question 1: Hillary Waters, CFA, is an investment analyst who has
accumulated several pieces of nonpublic information through her
contacts with drug firms. Although none of the information is
material, Waters correctly concluded by analyzing the nonpublic
information that the earnings of one of the drug firms would be
unexpectedly high in the coming year. Under current U.S. law,
Waters:
a) should urge the drug firm to make public dissemination of the
information immediately.
b) can use the information to make investment recommendations and
decisions.
c) may use the information, but only after approval from a
compliance officer or supervisory analyst attesting to its
non-materiality.
d) cannot legally invest or make investment recommendations based
on this information.
Question 2: According to "new classical" economists, what effect
will financing a reduction in current taxes by government
borrowing will have on aggregate demand? Aggregate demand will
be:
a) increased or reduced, depending on interest rate levels.
b) unaffected.
c) reduced.
d) increased.
Question 3: The constant-growth dividend discount model will not
produce a finite value if the dividend growth rate is:
a) below the market capitalization rate.
b) below its historical average.
c) above the market capitalization rate.
d) above its historical average.
Question 4: In contrast to the Capital Asset Pricing Model,
Arbitrage Pricing Theory:
a) specifies the number and identifies of specific factors that
determine expected returns.
b) does not require the restrictive assumptions of the market
portfolio.
c) uses risk premiums based on micro variables.
d) requires that markets be in equilibrium.
Answer 1: b
Rationale & Reference:
Under the "mosaic theory", financial analysts may use significant
conclusions derived from the analysis of public and nonmaterial
information as the basis for investment recommendations and
decisions even if those conclusions would have been material
inside information had they been communicated directly to the
analyst by a company.
1994 CFA Exam, #4, p.m.
Standards Handbook, pp. 141-146
Answer 2: b
Rationale & Reference:
New classical economists believe that the substitution of debt
for taxes will have no effect on aggregate demand or private
consumption. This is because individuals will save increases in
their current income due to lower taxes for higher future taxes
that they anticipate.
1994 CFA Exam, #55, p.m.
Gwartney & Stroup, p. 275
Answer 3: c
Rationale & Reference:
The infinite period (constant-growth) dividend discount model
will not produce a finite value if the dividend growth rate is
above the market capitalization rate (or the required rate of
return).
P = D/(k-g)
Where:
P = Price (or value) of the stock
D = Dividend
g = Sustainable growth rate of earnings and/or dividends
(expected growth rate)
k = Required rate of return (or market capitalization rate) on
the stock
Thus, if g > k, then the result will be meaningless because the
denominator becomes negative.
Note:
The term market capitalization rate is synonymous to the required
rate of return (or the discount rate). It is typically used when
valuing real estate.
1994 CFA Exam, #86, p.m.
Reilly & Brown, p. 443
Answer 4: b
Rationale & Reference:
Unlike the CAPM, the APT recognizes that there are many factors
that affect returns, such as inflation, GDP growth, political
upheaval, etc. The CAPM assumes that the only relevant risk
variable is an asset's beta (the covariance of the asset with the
market portfolio). The APT does not require the restrictive
assumptions of the CAPM.
Reilly & Brown, p. 323
1994 CFA Exam, #120, p.m.
*** Level II
Question: Learning Outcome Statement:
Analyze the alternative courses of action that are available to a
company when its sustainable growth exceeds or is less than its
actual growth.
Answer:
Management must determine if the problem is temporary or
long-term.
If temporary, management can simply continue accumulating
resources in anticipation of future growth.
If long-term, the issue then becomes whether the lack of growth
is industry-wide or unique to the company. If the problem is
company-specific, then management must look carefully at
performance in order to identify and remove the internal
constraints on company growth. This will involve organizational
changes and possible developmental expenses. If the outcome
reveals a long-term, company-specific problem that cannot be
solved internally, the firm has three options:
1. Ignore the problem: This response comes in two forms:
management can continue investing in its core businesses despite
the lack of attractive returns or it can simply sit on an
ever-larger pile of idle resources. Both responses are dangerous
since they attract corporate raiders because of the firm's
depressed stock price. Yet if current management owns most of the
shares of the company, corporate raiding is not an issue.
2. Return the money to shareholders: This solution implies
increasing dividends or repurchasing shares. Since the U.S. tax
code fully taxes dividends at the corporate and personal level,
American managers do not prefer this option. Consequently,
managers would rather invest in growth, even if the growth adds
no value for shareholders. Stockholders typically expect managers
to profitably invest their capital, and when money is returned to
stockholders it suggests the inability of managers to perform
this function. Studies suggest that executives commonly choose
growth over dividend distribution, because of concern for the
long-term viability of their organizations.
3. Buy growth: This solution suggests the firm diversifies and
finds better investment opportunities. Management systematically
searches for worthwhile growth opportunities in other, more
vibrant industries. High-growth and low-growth companies may
simultaneously solve their growth problems through merging.
Evidence exists however that from the shareholders' perspective,
buying growth is distinctly inferior to returning money to owners
since more often than not, superior growth prospects have high
stock prices. And after paying a substantial premium to acquire
another firm, the buyer is left with a mediocre investment or
worse.
Higgins, pp. 138-141
*** Level III
Question: Learning Outcome Statement:
Explain the steps to be taken in designing an effective
compliance program for investment organizations.
Answer:
Developing an effective compliance program involves six steps:
1. Obtain board and CEO support.
2. Review the firm's business activities and regulatory
environment. The program must fit the firm's activities and
applicable regulations.
3. Review competitors' programs so that industry standards can be
determined.
4. Draft a firm specific program. Be sure to include: designation
of a compliance officer, scope of the program; statement of
permissible conduct, procedures for reporting violations, and
enforcement actions. The program must be clear and understandable
to all employees.
5. Implement the program. Take the time to roll it our correctly.
6. Keep the program current.
Caccese, pp. 48-49
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