Free CFA-Level-II Mock Exam – Practice Online Confidently

Voyager Inc., a primarily internet-based media company, is buying The Daily, a media company with exposure to newspapers, television, and the internet.

James Walker is the Chief Financial Officer for Lothar Corporation, a U .S . mining company that specializes in worldwide exploration for and excavation of precious metals. Lothar Corporation generally tries to maintain a debt-to-capital ratio of approximately 45% and has successfully done so for the past seven years. Due to the time lag between the discovery of an extractable vein of metal and the eventual sale of the excavated material, the company frequently must issue short-term debt to fund its operations. Issuing these one to six month notes sometimes pushes Lothar's debt to capital ratio above their long-term target, but the cash provided from the short-term financing is necessary to complete the majority of the company's mining projects.

The board members for Kazmaier Foods have gathered for their quarterly board of directors meeting. Presiding at the meeting is the Chairman and CEO for Kazmaier, Phil Hinesman. The other eight members of the board are also present, including Allen Kazmaier, the brother of Kazmaier's founder; Elaine Randall, Executive Vice President for Emerald Bank, which Kazmaier uses to obtain short-term financing; and Bill Schram, Kazmaier's President and Chief Operating Officer. Each of the directors was elected to serve on the board for a 4-year term. They were elected two at a time over the past three years. With the exception of Hinesman, Allen Kazmaier, Randall, and Schram, board members had no ties to Kazmaier prior to joining the board and had no personal relationships with management. In addition to the regular board meetings, the five independent board members get together annually, in a meeting separate from the regular board meetings, to discuss the company's operations.
Item 1 on the board meeting agenda is a discussion about the importance of corporate governance and how Kazmaier can improve its corporate governance system. Hinesman begins the discussion by saying, 'A strong system of corporate governance is important to our shareholders. Studies have shown that, on average, companies with strong corporate governance systems have higher measures of profitability than companies with weak corporate governance systems.' Randall adds her comment to the discussion: 'The lack of an effective corporate governance system increases risk for our investors. If we do not have the appropriate checks and balances in place, our investors may be exposed to the risk that information used to make decisions about our firm is misleading or incomplete, as well as the risk that mergers or acquisitions the firm enters into will benefit management at the expense of shareholders.'
After a lengthy discussion, the board agrees on five separate recommendations that will enhance its current system of corporate governance. One of these recommendations is to change the function and structure of the board's audit committee. Currently the audit committee consists of Matthew Bortz, David Smith, and Ann Williams---three independent directors who each have backgrounds in finance and accounting. The board agrees that one more member should be added to the committee and that the committee should expand its list of responsibilities.
Item 2 on the agenda for the board of directors' meeting is a report from Kazmaicr's Chief Financial Officer, Doug Layman. The following information was included in the material that was distributed to each board member before the meeting:
Current share price: $40.00
Shares outstanding: 56, 250,000
Estimated earnings: $112.5 million
Planned capital spending: $150 million
Target debt-to-equity ratio 1 to I
Cost of equity: 8.0%
Constant growth rate: 5.2%
Layman tells the board that his analysis indicates that, based on a constant-growth dividend discount model, the initiation of an $0.80 per share dividend would reduce the cost of equity by 1.2% and increase the value of the firm's stock, assuming that earnings, the cost of debt, and the constant growth rate don't change.
Item 3 on the agenda is the sale of Kazmaier's condiment packaging division to Sautter Packaging and Supply Company. Layman believes the sale will net the company $50 million, payable in cash. After discussing the pros and cons of selling the division, the directors agree that the sale is in the best interests of the company and its shareholders. The directors then move to a vote, and the sale of the condiment packaging division is approved unanimously. The committee then moves on to discuss what to do with the proceeds from the sale. Williams suggests that paying out the $50 million to shareholders as a special dividend would continue to give the firm flexibility in how it uses its excess cash. Smith tells the board that a share repurchase can be thought of as an alternative to a cash dividend, and that if the tax treatment between the two alternatives is the same, investors should be indifferent between the two. After debating the merits of special dividends and stock repurchases, Kazmaier's board authorizes the proceeds from the sale of the condiment packaging division to be used for the purchase of $50 million worth of outstanding shares.
An external agency recently included Kazmaier in a review of corporate governance systems to determine whether or not the structure of the board of directors was consistent with corporate governance best practices. The agency scored companies based on the following criteria:
Criterion 1: Composition of the board of directors.
Criterion 2: Chairman of the board of directors.
Criterion 3; Method of electing the board.
Criterion 4: Frequency of separate sessions for independent directors.
Each of the four criteria was weighted equally, with the firm receiving a positive mark for being in compliance with corporate governance best practice.
A month after the board meeting, the price of Kazmaier stock is still at $40 per share, and the sale of Kazmaier's condiment packaging division does not go through. In order to finance the approved share repurchase, Kazmaier is forced to borrow funds. Schram states, 'I am concerned that the cost of the debt used to repurchase shares may cause a reduction in earnings per share.'
Jennifer Nagy, a vice president in Kazmaier's finance division, tells Schram not to be concerned about using debt to finance the share repurchase because the rationale behind the repurchase is sound. Nagy then writes down some of the common rationales for share repurchases and hands them to Schram.
Rationale 1: Repurchasing shares can prevent the EPS dilution that comes from the exercise of employee stock options.
Rationale 2: Management can use a share repurchase to alter the company's capital structure by decreasing the percentage of equity.
Rationale 3: Like a dividend increase, a share repurchase is a way to send a signal to investors that Kazmaier's management believes the outlook for the company's future is strong.
Are the comments made by Hinesman and Randall about corporate governance systems correct?

Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.
Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.
Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.
Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.
Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.
Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.
* If a firm anticipates floating rate exposure from issuing floating rate bonds at some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.
* Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.
Based on the results from Reichmann's binomial interest rate model, the value of a 2-year, $30 million European put option on LIBOR with a floor strike of 6% is closest to: