Question 1

Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. Tf the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company's revenues will increase by $175,000 and costs by $25,000 for each year of the equipment's 3-year life. There is no expected change in net working capital.
The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of-$62,574.
What is the IRR based on Malfoy's NPV estimate, and should the project be accepted or rejected in order to maximize shareholder value?
IRR Project

Options :

A : 8.8?cept

B : 8.8% Reject

C : 21.5?cept

Answer: B

Question 2

Trent Black is a government fixed-income portfolio manager and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate. Black notes the following term structure:

Black is also evaluating receiver and payer swaptions on the same $30 million interest rate swap. The swaptions are European-style swaptions that mature in 240 days. Black anticipates a decline in interest rates and would like to use the swaptions to profit from his interest rate forecast.
Black is also concerned about the potential credit risk inherent in both interest rate swaps and swaptions, so he consults Marcus Coleman, a contract specialist in the legal department. Coleman advises Black that:
Statement 1: The fixed rate payer in any plain vanilla interest rate swap is exposed to potential credit risk at the initiation of the swap but the floating rate payer is not.
Statement 2: The long position is exposed to potential credit risk in a payer swaption at initiation but the short
position in a payer swaption is not.
On May I after 120 days. Black is asked to determine the value of the 2-year, $30 million swap. The term structure after 120 days is:

Is Coleman correct with respect to the credit risk of swaps and swaptions?

Options :

A : Correct on both statements.

B : Only correct on Statement 1.

C : Only correct on Statement 2.

Answer: C

Question 3

Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.
The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.
Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, 'Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?'
Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:
* The risk-free rate of return is 2.7%.

* The expected risk premiums arc:

* The beta coefficient in the CAPM is estimated to be 0.63.
* The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.
Trotter also asks Tang about adjusted betas. She says, 'We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?'
Trotter has one final question for Tang. Trotter says, 'We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes.'
The best response to Trotter's question about survivorship bias is:

Options :

A : historical estimates.

B : Gordon model estimates.

C : survey estimates.

Answer: A

Question 4

Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.
Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the 'neglected firm effect,' in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be 'neglected.'
Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:
Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei
where:
Ri = the rate of return on stock i
COVERAGEi = one if there are three or fewer analysts covering stock
i, and equals zero otherwise
LN(SIZEi) = the natural logarithm of the market capitalization
(stock price times shares outstanding) for stock i,
units in millions
FORECASTi = the 1-year consensus earnings growth rate forecast for stock i

Pilchard derives the following results from her cross-sectional regression:

The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.
Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.

Pilchard derives the ANOVA table for her regression. In her ANOVA table, the degrees of freedom for the regression sum of squares and total sum of squares should equal:

Options :

A : 3 and 30, respectively.

B : 4 and 29, respectively.

C : 3 and 29, respectively.

Answer: C

Question 5

Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The Fund's total assets are valued at $3.5 billion. The investment policy uses a total return approach to meet the return objective that includes a spending rate of 5%. In addition, the policy constraints established make tax-exempt instruments an inappropriate investment vehicle. The Fund's current asset mix includes an 18% allocation to private equity. The private equity allocation is shown in Exhibit 1.

The private equity allocation is a mixture of funds with different vintages. For example, within the venture capital category, investments have been made in five different funds. Exhibit 2 provides detail about the Alpha Fund with a vintage year of 2006 and committed capital of SI95 million.

The Alpha Fund is considering a new investment in Targus Company. Targus is a start-up biotech company seeking $9 million of venture capital financing. Targus's founders believe that, based on the company's new drug pipeline, a company value of $300 million is reasonable in five years. Management at Alpha Fund views Targus Company as a risky investment and is using a discount rate of 40%. After a thorough analysis of Targus's future prospects, Alpha Fund's management believes that there is a possible 15% risk of failure for the company.
Using Exhibit 2 and assuming a 20?rried interest, the Alpha Fund's 2008 dollar amount of carried interest is closest to:

Options :

A : $0 million.

B : $10 million.

C : $20 million.

Answer: B

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