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*** Level I
Question 1: Which of the following would not be included as an
asset on a corporate balance sheet?
a) Marketable securities
b) Buildings
c) Inventory
d) Accounts receivable
e) Common stock
Question 2: An auditor will express an adverse opinion if
a) a violation of GAAP is sufficiently material that a qualified
opinion is not justified.
b) none of these answers.
c) the firm' s ability to continue as a going concern is subject
to substantial doubt.
d) a qualified opinion cannot be expressed because the auditor
lacks independence.
e) a severe scope limitation has been imposed by the client.
Question 3: The criterion to apply the equity method of
accounting for investments of 50% or less is that there is an
ability to exercise significant influence over the investee. A
20% or greater ownership is a presumptive indication of that
ability. Which example below does not indicate an inability to
exercise significant influence over an investee even though the
investor owns 30% of the common stock of the investee?
a) The majority ownership of the investee is spread among a large
group of shareholders who have objectives with respect to the
investee that differ from those of the investor.
b) None of these answers.
c) Opposition by the investee, such as litigation or complaints
to governmental regulatory authorities, challenges the investor's
exercise of significant influence.
d) The investor tries and fails to obtain representation on the
investee's board of directors.
e) The investor and investee sign an agreement under which the
investor surrenders significant rights.
Question 4: Vision Co. maintains a defined benefit pension plan
for its employees. The service cost component of Vision's net
periodic pension cost is measured using the
a) actual return on plan assets.
b) expected return on plan assets.
c) unfunded vested benefit obligation.
d) projected benefit obligation (PBO).
e) unfunded accumulated benefit obligation.
Answer 1: e
Rationale & Reference:
Common stock. Common stock is not as asset; it represents funds
received from the sale of stock to owners of the firm. It is
ownership equity, not an asset.
Bernstein & Wild, pp. 11-12
Answer 2: a
Rationale & Reference:
The auditor will express a qualified opinion when the statements
are fairly presented in accordance with GAAP except for the
effects of the matter to which the qualification applies. When
the statements as a whole are not fairly presented in conformity
with GAAP, a qualified opinion will be inappropriate, and an
adverse opinion must be expressed.
Bernstein & Wild, pp. 18-19
Answer 3: a
Rationale & Reference:
If the investor owns 20% to 50% of an investee and the remainder
of the ownership is spread among a large group of shareholders,
the investee will be able to exert significant influence even
though most of the other owners have objectives contrary to those
of the investor. The presumption of significant influence could
be overcome by evidence that majority ownership is held by a
small number of shareholders who operate the investee without
regard to the investor's views.
Bernstein & Wild, pp. 182-184
Answer 4: d
Rationale & Reference:
Service cost is the actuarial present value of benefits
attributed by the pension benefit formula to services rendered
during the period. The PBO is equal to the actuarial present
value of all benefits attributed by the pension benefit formula
to employee service rendered prior to that date. The PBO is
measured using assumptions as to future salary levels.
Bernstein & Wild, pp. 114-115
*** Level II
Question:
Learning Outcome Statement:
Demonstrate the difference between the market value of equity and
the market value of the company.
Answer:
1. Valuing Equity - The most direct way to estimate going-concern
value is to think of the target company as if it were nothing
more than a large, capital-expenditure opportunity. The central
issue then is to determine if tomorrow's benefits justify today's
costs. This is most easily accomplished by calculating the
present value of expected future cash flows to equity.
Thus: FMV of equity = Present value of expected future cash flows
to equity.
This formula says that the maximum price a minority investor
should pay for the equity of a business equals the present value
of expected future cash flows to the investor, discounted at an
appropriate, risk-adjusted rate. The weakness of this approach is
that investment and financing decisions should be considered
separately. The FMV of equity approach cannot separate these two
steps since cash flows to equity and the valuation of equity both
depend on the value of the business and its financing. This
problem is alleviated by calculating the FMV of the firm rather
than of the equity.
2. Valuing the Firm - The best approach to the investment
decision is to first decide if the investment makes economic
sense regardless of how it is financed and then to decide how
best to finance it.
The FMV of the firm equals the present value of expected
after-tax cash flows available for distribution to owners and
creditors, discounted at an appropriate risk-adjusted rate:
FMV of firm = PV {Expected after-tax cash flows to owners and
creditors}. Where the term in brackets is the firm's free cash
flow (FCF) defined as EBIT (1-tax rate) + Depreciation -
Investment. FCF is the cash flow available for distribution to
owners and creditors after undertaking all worthwhile investment
opportunities.
Because the cash flow being discounted here accrues to the firm,
not to equity, the appropriate risk-adjusted discount rate in the
above formula is the target firm's weighted-average cost of
capital. This approach reflects the benefits of the particular
capital structure employed by the firm in the discount rate, not
the cash flows.
Once the FMV of the firm is known, the FMV of equity can be
easily deduced by recalling that:
Value of equity = Value of firm - Value of liabilities
The value of liabilities may be estimated by their book value if
they are reasonably short term and interest rates have not
changed dramatically.
Higgins, pp. 335-338
*** Level III
Question:
Learning Outcome Statement:
Discuss the factors involved in establishing appropriate
benchmarks for international portfolios and in determining how
much of an international portfolio should be currency hedged.
Answer:
One problem is that separate benchmarks are typically used for
U.S. equity and for U.S. bonds, and for non-U.S. equity and
non-U.S. bonds.
The choice of a benchmark is important because it strongly
influences the investment strategy of money managers. Once
chosen, the manager will seek to match or exceed the performance
of the benchmark through use of a similar strategy.
A benchmark should be widely accepted, easy to replicate, and
have a strong conceptual foundation.
Because of the relative independence of market and currency
movements, international asset allocations that differ from that
of the benchmark can lead to marked differences in performance.
A proper benchmark must represent an asset allocation that can be
easily reproduced in the marketplace. (e.g. an index with full
currency hedge would be difficult and costly).
With regard to currency hedging, it is not available in most
currencies, so hedging strategies must rely on imperfect
cross-hedging.
There is no optimal currency hedging policy. As hedging is costly
and time consuming the development of a hedging strategy will
depend on the % of foreign assets in the portfolio and the
allocation between foreign stocks and bonds (each asset class
will require a different strategy).
Odier & Solnik, pp. 63-68 |
