CFA L2 Apostila 01 Exame 2018 - COMPLETA IMPRESSÃO

Since we are using the current rate method, the items in the income statement are translated atthe average exchange rate. The average rate is (2.5 + 3) / 2 = 2.75 Australian dollars per $1.Income Statement (in $)Sales (3,500 / 2.75) $1,272Costs (2,900 / 2.75) $1,055Net Income $217Question 15The correct answer was B) $110.Since we are using the current rate method, all balance sheet accounts are translated at the currentexchange rate, except fo r the common stock account, which is translated at the historical rate.A/R: (330 / 3) = 110Question 16The correct answer was C) cumulative translation adjustment lossAPJ shows a net asset:Total assets A$1,530 / (3.00 A$/US$) = US$510 Total liabilities A$210 / (3.00 A$/US$) = US$70Net asset = US$440Because the functional currency is the local currency, the current rate method is used. When wehave a net asset balance sheet exposure, a weakening foreign currency will result in a negativetranslation adjustment. AJP's net asset position will result in a cumulative transaction adjustmentloss as the foreign currency, the A$, is depreciating.Exposure Foreign CurrencyCurrent rateApprecia Depreciatmethod: ting ingNet assets Gain LossNet liabilities Loss GainQuestion 17The correct answer was C) remeasurement loss.APJ has a net monetary asset exposure:Total monetary assets: Cash + A/R A$771 / (3.00 A$/US$) = US$257 Total monetary liabilities:A$210 / (3.00 A$/US$) = US$70Net monetary asset = US$187Because the functional currency is the reporting currency, the temporal method is used and thismeans there is remeasurement - a loss as the foreign currency, the A$, is depreciating.Exposure Foreign CurrencyTemporal Apprecia Depreciatmethod: ting ingNet monetaryGain LossassetsNet monetaryLoss GainliabilitiesQuestion 18The correct answer was B) a loss of US$137.Australian Puddle JumpersBalance Sheet Cash 2012 (A$) Rate (A$/US$) 2012 (US$)A/R 441 3.00 $147 330 3.00 $110 _________________________ 3 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

Maintenance Supplies 291 3.00 $97Current assets 1062 3.00 $354Net Fixed Assets 468 $156Total Assets 1,530 3.00 $510 Historical*Accounts payable (A/P) 210 from I/S $70 $360Common Stock 720 $217 ($137)Retained Earnings 600 $440 $510CTATotal equities 1,320Total Liabilities and equity 1,530*From 2011 USD Balance SheetQuestions 19 - 24Question 19The correct answer was C) Service Cost Expected return on plan assetsService cost and interest cost are considered to be actual events. Expected return on plan assets,amortization of unrecognized prior service costs, and amortization and deferral of actuarial gainsand losses are classified as smoothed events. Together, these five components are used to calculatea plan's reported pension expense or income on the income statement. Total periodic pension costis actual cost (not smoothed) of the plan - but not reflected fully in the reported pension expense.Question 20The correct answer was A) a decrease in PBO of $1.6 million.A higher discount rate will result in lower PBO. Reconciliation of opening and closing PBO shows: Beginning PBO $21 million Given (+) Interest cost 1.6 Given (+) Service cost 3.0 Given (-) Benefits paid (1.0) Given (-) Actuarial Changes (1.6) PLUG (=) Ending PBO $23 million GivenChanges due to actuarial assumptions = −$1.6mQuestion 21The correct answer was C) actual return on assets, employer contributions, and benefits paid.Companies are required to disclose a reconciliation of the beginning and ending balances of the fairvalue of plan assets, which can be calculated as follows:Fair value of plan assets at the beginning of the year+ Actual return on assets+ Employer contributionsBenefits paid= Fair value of plan assets at the end of the yearQuestion 22The correct answer was C) The funded status of the plan. _________________________ 4 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

The current standard requires companies to report the funded status of the plan, which is thedifference between the PBO and the fair value of plan assets.Question 23The correct answer was C) −$2.0 million.The funded status is the difference between the PBO and the fair value of plan assets as of thereporting date. For Midwest's plan, $21,000,000 − 23,000,000 = −$2,000,000. PBO figure isalready given - and it includes all unrecognized items (and hence need not be adjusted).Question 24The correct answer was C) The balance sheet will now reflect the true economic position of thepension plan, but the income statement will not necessarily reflect a true measure of economicpension expense.Because deferred and unrecognized items are required to be reported on the balance sheet but notthe income statement, the balance sheet will reflect the true economic position of the pension plan,but the income statement will not necessarily reflect a true measure of economic pension expense.U.S. GAAP and IFRS still differ with respect to reporting pension expense.Questions 25 – 30Question 25The correct answer was C) $175,000.Under the equity method, dividends are not included as income to the acquirer. ($700,000 × 0.25)= $175,000 will be the reported investment income for Birch.Question 26The correct answer was B) $52,500.The cash flow to Birch will be the dividend received ($700,000)(0.30)(0.25) = $52,500.Question 27The correct answer was C) $175,000Birch would recognize 25% of the net income = $700,000 × 0.25 = $175,000. This would berecognized line by line to include the full $700,000, then 75% would be removed as belonging tothe non controlling interest.Question 28The correct answer was C) Reason 1Birch owns 1,500/6,000 = 25% of the common shares of TRQ. This suggests significant influencewhich would make equity accounting appropriate. The percentage of preferred shares owned is notrelevant.Question 29The correct answer was C) Impact two onlyIf TRQ is a subsidiary it will be consolidated on a line by line basis. This will affect liquidity ratios.Revenue will be in creased but net income unaffected by the treatment as in both cases (associateand subsidiary) Birch's share of TRQ's net income will be included in the income statement.Question 30The correct answer was C) The contingent liabilities would not be recognized in the balance sheet orincome statement on acquisitionAs the financial effect of the contingent liabilities cannot be reasonably estimated, under U.S. GAAP theyshould not be included. _________________________ 5 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

_________________________ 6 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio

Fixed IncomFeinIannvceaiasnltdRmAeepnnoalrtytsisnigs Earnings Quality Issues and Financial Ratio Analysis 20. Integration of Financial Statement Analysis TechniquesLOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Analysis Earnings sources and performance Asset base Capital structure Capital allocation decisions Earnings quality and cash flow analysis Market value decomposition Off-balance-sheet financing Anticipating changing accounting standards© Kaplan, Inc. 2 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysis Financial Statement Analysis Techniques Foundation Concepts Note: Many of the “adjustments” mentioned in this topic review are discussed elsewhere in the curriculum at levels I and II The point of this topic review is to “put it all together” (i.e., to detail how to take the individual adjustments and restate the financial statements) before calculating ratios© Kaplan, Inc. 1LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Earnings Sources and ROEAssess the firm’s performance drivers bydecomposing ROE using the extended DuPontequation Tax Interest EBIT Asset Financialburden burden margin turnover leverageROE = NI  EBT  EBIT  Revenue  Average assets EBT EBIT Revenue Average assets Average equity© Kaplan, Inc. 3ers - Exame CFA 1

LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis TechniquesEarnings Sources and ROE (cont.) Determine whether the firm’s earnings are generated internally (from operations), from acquisitions, or from investment income from associates (equity method)Adjustment  Remove equity method income and the investment asset from the extended DuPont equation© Kaplan, Inc. 4LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis TechniquesEquity Method Adjustment: Example(¥ in millions) 20x9 20x8 20x7 Revenue ¥52,000 ¥48,300 EBIT EBT 7,250 6,500 Equity income* 6,600 5,900 Net income 900 700 5,570 4,800 Total assets ¥56,200 ¥49,900 ¥50,300 Equity investment 4,400 4,100 3,500 Stockholders’ equity 26,600 25,900 24,000 * Not included in EBT 6© Kaplan, Inc. ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Earnings Sources and ROE (cont.)Equity method earnings after the tax line NI – equity Typical = leave unadjusted accounted unless the financing of the earnings investment is knownROE = NIadj  EBT  EBIT  Revenue  Average assets EBT EBIT Revenue Average assetsadj Average equity Assets – carrying value of equity 5 accounted investment© Kaplan, Inc.LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Equity Method Adjustment: ExampleAs reported 20x9 20x8Tax burden 84.4% 81.4%× Interest burden 91.0% 90.8%× EBIT margin 13.9% 13.5%= Net profit margin 10.7% 10.0%× Total asset turnover× Financial leverage 0.98 0.96= ROE 2.0 2.0 21.0% 19.2%© Kaplan, Inc. 7ers - Exame CFA 2

LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis TechniquesEquity Method Adjustment: Solution(¥ in millions) 20x9 20x8 20x7Net income ¥5,570 ¥4,800– Equity income ¥50,300= Adj. net income 900 700 3,500/ EBT ¥4,670 ¥4,100= Adj. tax burden ¥46,800Total assets 6,600 5,900– Investment asset 70.8% 69.5% ¥56,200 ¥49,900= Adj. total assets 4,400 4,100 ¥51,800 ¥45,800© Kaplan, Inc. 8LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Capital Allocation DecisionsConsolidation can hide the individual characteristicsof dissimilar subsidiariesFirms must disaggregate financial information intosegments to assist usersSegment disclosures are valuable in identifying:  Revenue and profit by segment  The relationship between capital expenditures and returns  Segments that should be de-emphasized© Kaplan, Inc. 10 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Equity Method Adjustment: SolutionAdjusted 20x9 20x8Adj. tax burden1 70.8% 69.5%× Interest burden 91.0% 90.8%× EBIT margin 13.9% 13.5%× Adj. total asset turnover2 1.1 1.0× Financial leverage3 2.0 2.0= ROE 19.7% 17.0% 1 Adj. net income / EBT 9 2 Revenue / Average adj. total assets 3 No adjustment made without details of how investment was financed© Kaplan, Inc.LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Segmental AnalysisReportable business or geographic segment:50% of its revenue from sales external to the firmand at least 10% of a firm’s revenue, earnings, orassets:  For each segment, firm reports limited financial statement information.  For primary segments, must report revenue (internal and external), operating profit, assets, liabilities (IFRS only), capex, depreciation, and amortization. 11© Kaplan, Inc.ers - Exame CFA 3

LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Divisional AnalysisCompute % of revenue from each division % of assets used by each division % of operating profit (EBIT) contributed by each division % of capex attributed to each Segment EBIT division Segment sales  Divisional margin % capex 12  Resource allocation % assets© Kaplan, Inc.LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Segment Disclosure: Example Revenue EBITSeg 20x9 20x8 20x9 20x8AB $270 20% $220 18% $60 29% $50 27%C 870 66% 820 68% 140 63% 120 65% 180 14% 170 14% 15 7% 15 8% $1,320 $1,210 $205 $185 Segment B contributes the highest revenue and EBIT while C contributes the lowest.© Kaplan, Inc. 14 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Segmental AnalysisIf ratio of proportional capex to proportional assets isgreater than 1:  Firm is growing the segment by allocating more resources to the segmentIf ratio of proportional capex to proportional assets isless than 1:  Firm is allocating less resources to the segment  If trend continues, the segment will become less significant over time© Kaplan, Inc. 13LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Segment Disclosure: Example Total Assets CapexSeg 20x9 20x8 20x9 20x8A $370 36% $170 21% $10 15% $9 17%B 500 49% 490 60% 35 54% 30 56%C 160 15% 150 19% 20 31% 15 28% $1,030 $810 $65 $54 Segment B has highest assets and capex Segment C has the lowest assets Segment A has the lowest capex© Kaplan, Inc. 15ers - Exame CFA 4

LOS 20.a,b Demonstrate/Identify/Explain Financial StatementSchweser B2 pg 128, CFAI V2 pg 271 Analysis Techniques Segment Disclosure: Solution Operating Margin Capex%/Asset%Seg 20x9 20x8 20x9 20x8A 22% 23% 0.42 0.81B 15% 15% 1.10 0.93C 8% 9% 2.07 1.47 C has lowest EBIT margin and it is declining C’s proportional capex to proportional asset ratiois > 1 indicating over-allocation of resources to lowest margin segment 16© Kaplan, Inc.LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Measuring Earnings QualityEarnings have a cash flow component and anaccrual componentAggregate accruals = Accrual Cash based – earnings earningsAggregate accruals can be measured using either: Balance sheet approach Cash flow statement approachInverse relationship in accruals and earnings quality© Kaplan, Inc. 18 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.e Analyze Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Earnings Quality Persistent and sustainable earnings are considered “high quality” Recall that earnings can be disaggregated into cash flow and accruals using a:  Balance sheet approach  Cash flow statement approach Measure earnings quality using the ratio of accruals to average net operating assets  Interpretation: Lower ratio, higher quality© Kaplan, Inc. 17LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Balance Sheet Based AccrualsNet operating = (Total assets – (Total liabilitiesassets (NOA) – cash*) – total debt) Aggregate = NOAt – NOAt–1 accruals Accruals = Aggregate accruals ratio (NOAt + NOAt–1) / 2*Also includes cash equivalents and marketable securities© Kaplan, Inc. 19ers - Exame CFA 5

LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Cash Flow Based Accruals Aggregate = NI – (CFOt + CFIt) accruals Issue—different treatment of finance costs and dividends under IAS and U.S. GAAP Accruals = Aggregate accruals ratio (NOAt + NOAt–1) / 2© Kaplan, Inc. 20LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Cash Flow Analysis (cont.) Calculate cash basis ratios:  Cash flow to reinvestment  Adjusted OCF / capital expenditures  Cash flow interest coverage  Adjusted OCF / cash interest  Cash flow to total debt  Adjusted OCF / total debt© Kaplan, Inc. 22 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Cash Flow Analysis Determine whether earnings are confirmed with cash flow  Adjust operating cash flow (OCF) by adding- back cash interest and cash taxes if included  Compare adjusted OCF to operating income Calculate cash basis ratios:  Cash flow return on assets  OCF / average total assets  Operating earnings quality  Adjusted OCF / EBIT© Kaplan, Inc. 21LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques Market Value Decomposition Determine the implied value of the parent excluding the value of associates X Market capitalization of parent – Parent’s share of associates’ market cap = Implied value of parent Note: It may be necessary to convert the associates’ market cap to the parent’s reporting currency at the current exchange rate© Kaplan, Inc. 23ers - Exame CFA 6

LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis TechniquesMarket Value Decomposition (cont.) Next, determine the implied P/E of the parent by eliminating the associates’ income from the parent = Implied value of parent excluding associates Net income – Parent's share of associates' earnings Note: It may be necessary to convert the associates’ earnings to the parent’s reporting currency using the average exchange rate© Kaplan, Inc. 24LOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques MV Decomposition: SolutionImplied Red value excluding BlackRed market cap $60,000– Share of Black 10,200 (£20,000 × 30% × $1.70) $49,800Implied Red net income excluding BlackRed net income $5,000– Share of Black NI 480 (£1,000 × 30% × $1.60) $4,520 Implied Red P/E 11.0 ($49,800 / $4,520) Actual Red P/E 12.0 ($60,000 / $5,000)© Kaplan, Inc. 26 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.e Analyze/Interpret Financial StatementSchweser B2 pg 138, CFAI V2 pg 298 Analysis Techniques MV Decomposition: ExampleRed Corporation, located in the U.S., owns 30% ofBlack Company which is located in the U.K. Red BlackMarket capitalization $60,000 £20,000Net income $5,000 £1,000Current FX rate ($ / £) $1.70Average FX rate ($ / £) $1.60© Kaplan, Inc. 25LOS 20.c Analyze/Interpret Financial StatementSchweser B2 pg 144, CFAI V2 pg 289 Analysis Techniques Off-Balance-Sheet Financing For analytical purposes, treat an operating lease as a finance (capital) lease  Increase assets and liabilities by the present value of the remaining lease payments  Remove rent expense (payment) from the income statement and replace with depreciation expense and interest expense  Result: Higher leverage and lower interest coverage© Kaplan, Inc. 27ers - Exame CFA 7

LOS 20.c Analyze/Interpret Financial StatementSchweser B2 pg 144, CFAI V2 pg 289 Analysis Techniques Lease Capitalization: ExampleTex Inc. is the lessee in an operating lease. The PVof lease payments is €30 million discounted at aninterest rate of 10%. The lease term is 6 years andthe annual payment is €6.9m.Adjust the following for the lease and calculateTex’s total debt-to-equity and interest coverageratios: €100 million Reported RatiosTotal Debt €50 million Debt / EquitySH Equity 2.0EBIT €6 million Interest coverage Interest Expense €2 million 3.0© Kaplan, Inc. 28LOS 20.c Analyze/Interpret Financial StatementSchweser B2 pg 144, CFAI V2 pg 289 Analysis Techniques Off-Balance-Sheet Financing Other OBS techniques: receivable sale with recourse, debt guarantee, and take-or-pay agreement© Kaplan, Inc. 30 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio AnalysisLOS 20.c Analyze/Interpret Financial StatementSchweser B2 pg 144, CFAI V2 pg 289 Analysis Techniques Lease Capitalization: SolutionAdjusted Ratios (€ in millions)Total Debt €130 [€100 Debt + €30 PV lease]SH Equity €50Adjusted D/E 2.6EBIT €7.9 [€6 EBIT + €6.9 PMT – (€30 / 6 Yrs)]Interest Expense €5.0 [€2 Interest Exp + (€30×10%)]Adjusted coverage 1.6© Kaplan, Inc. 29 Financial Statement Analysis Techniques Other LOS for Study Session 6These LOS are not covered in live class: Reading 19: All LOS Reading 20: LOS a © Kaplan, Inc. 31ers - Exame CFA 8

Fixed IncomFeinIannvceaiasnltdRmAeepnnoalrtytsisnigs Study Session 6 Discussion Questions CFA Institute Program curriculum, Level II, Volume 2, page 308 Questions 9–15 Discussion QuestionsExhibit 1. Selected Financial Data for Bickchip Enterprises(€ Thousands)Revenue 2009 2008 2007Earnings before interest and tax 72,448 66,487 55,781Earnings before taxNet income 6,270 4,710 3,609Asset turnover 5,101 4,114 3,168Assets/Equity 4,038 3,345 2,576 0.79 0.76 0.68 3.09 3.38 3.43© Kaplan, Inc. 34 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysis Discussion Questions The following information relates to Questions 9–15 Quentin Abay, CFA, is an analyst for a private equity firm interested in purchasing Bickchip Enterprises, a conglomerate. His first task is to determine the trends in ROE and the main drivers of the trends using DuPont analysis. To do so he gathers the data in Exhibit 1.© Kaplan, Inc. 33 Discussion Questions After conducting the DuPont analysis, Abay believes that his firm could increase the ROE without operational changes. Further, Abay thinks that ROE could improve if the company divested segments that were generating the lowest returns on capital employed (total assets less non-interest-bearing liabilities). Segment EBIT margins in 2009 were 11 percent for Automation Equipment, 5 percent for Power and Industrial, and 8 percent for Medical Equipment. Other relevant segment information is presented in Exhibit 2.© Kaplan, Inc. 35ers - Exame CFA 9

Discussion QuestionsExhibit 2. Segment Data for Bickchip Enterprises (€ Thousands) Capital Employed Capital Expenditures (Excluding Acquisitions)Operating Segments 2009 2008 2007 2009 2008 2007Automation Equipment 10,705 6,384 5,647 700 743 616Power and Industrial 15,805 13,195 12,100 900 849 634Medical Equipment 22,870 22,985 22,587 908 824 749 49,380 42,564 40,334 2,508 2,416 1,999© Kaplan, Inc. 36 Discussion QuestionsExhibit 3. Earnings Quality Data for Bickchip Enterprises (€ Thousands)Net income 2009 2008 2007Net cash flow provided by (used in) operating activitya 4,038 3,345 2,576 9,822 5,003 3,198Net cash flow provided by (used in) investing activity (10,068) (4,315) (5,052)Net cash flow provided by (used in) financing activityb (5,792) 1,540 (2,241)Average net operating assets 43,192 45,373 40,421a includes cash paid for taxes of: (1,930) (1,191) (1,093)b includes cash paid for interest of: (1,169) (596) (441)© Kaplan, Inc. 38 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysis Discussion Questions Abay is also concerned with earnings quality, so he intends to calculate Bickchip’s cash-flow-based accruals ratio and the ratio of operating cash flow before interest and taxes to operating income. To do so, he prepares the information in Exhibit 3.© Kaplan, Inc. 37 Discussion Questions Question 99. Over the three-year period presented in Exhibit 1, Bickchip’s return on equity is best described as:A. stable.B. trending lower.C. trending higher. © Kaplan, Inc. 39ers - Exame CFA 10

Discussion Questions Solution 9ROE = net margin×asset T/O×fin leverage2007 = 2,576/55,781×0.68×3.43 = 10.8%2008 = 3,345/66,487×0.76×3.38 = 12.9%2009 = 4,038/72,448×0.79×3.09 = 13.6%ROE is trending higher© Kaplan, Inc. 40 Discussion Questions Solution 10ROE = net margin × asset T/O × fin leverage2007 = 4.62% × 0.68 × 3.43 = 10.8%2008 = 5.03% × 0.76 × 3.38 = 12.9%2009 = 5.57% × 0.79 × 3.09 = 13.6% Margin Asset T/O Leverage increasing increasing decreasing© Kaplan, Inc. 42 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysis Discussion Questions Question 1010.Based on the DuPont analysis, Abay’s belief regarding ROE is most likely based on:A. leverage.B. profit margins.C. asset turnover.© Kaplan, Inc. 41 Discussion Questions Question 1111.Based on Abay’s criteria, the business segment best suited for divestiture is:A. medical equipment.B. power and industrial.C. automation equipment. © Kaplan, Inc. 43ers - Exame CFA 11

Discussion Questions Solution 11Segment EBIT Capital % Capital Capital % Capital Margin Employed Employed Expenditure ExpenditureAutomation 11% 10,705 21.7% 700 27.9% 5% 15,805 32.0% 900 35.9%Power and Ind 8% 22,870 46.3% 908 36.2% Medical 49,380 2,508 EquipPower and Industrial has lowest EBIT margin but uses 32% ofCapital Employed and 35.9% of capital expenditure.The segment’s % of cap ex is higher than the % of cap emp© Kaplan, Inc. 44 Discussion Questions Solution 12Cash-flow-based accruals ratio:[Net income – (CFO+CFI)] / Average NOA= [4,038 – (9,822 – 10,068)] / 43,192= 9.9%© Kaplan, Inc. 46 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysis Discussion Questions Question 1212.Bickchip’s cash-flow-based accruals ratio in 2009 is closest to:A. 9.9%.B. 13.4%.C. 23.3%.© Kaplan, Inc. 45 Discussion Questions Question 1313.The cash-flow-based accruals ratios from 2007 to 2009 indicate: A. improving earnings quality. B. deteriorating earnings quality. C. no change in earnings quality. © Kaplan, Inc. 47ers - Exame CFA 12

Discussion Questions Solution 13Cash-flow-based accruals ratios:2007 = [2,576 – (3,198 – 5,052)] / 40,421 = 11.0%2008 = [3,345 – (5,003 – 4,315)] / 45,373 = 5.9%2009 = [4,038 – (9,822 – 10,068)] / 43,192 = 9.9%As the accruals ratio has fallen, earnings qualityhas improved.© Kaplan, Inc. 48 Discussion Questions Solution 14Cash flow from operations 9,822Cash taxes paid 1,930CFO before interest and tax 11,752Note: Interest was included as CFF sodoes not require adjusting (CFO is alreadybefore interest) Ratio = 11,752/6,270 = 1.9 50© Kaplan, Inc. ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysis Discussion Questions Question 1414.The ratio of operating cash flow before interest and taxes to operating income for Bickchip for 2009 is closest to: A. 1.6. B. 1.9. C. 2.1.© Kaplan, Inc. 49 Discussion Questions Question 1515.Based on the ratios of operating cash flow before interest and taxes to operating income, Abay should conclude that:A. Bickchip’s earnings are backed by cash flow.B. Bickchip’s earnings are not backed by cash flow.C. Abay can draw no conclusion due to the changes in the ratios over time.© Kaplan, Inc. 51ers - Exame CFA 13

Discussion Questions Solution 152007 = (3,198 + 1,093) / 3,609 = 1.22008 = (5,003 + 1,191) / 4,710 = 1.32009 = (9,822 + 1,930) / 6,270 = 1.9As the ratio is rising, the level of earnings back bycash is increasing© Kaplan, Inc. 52 ©2018 FK Partne

SS 06 - Earnings Quality Issues and Financial Ratio Analysisers - Exame CFA 14

Questions - SS06 - Financial Reporting and Analysis Quality of Financial Reports and Financial Statement AnalysisQuestion 1 - 5Hatfield Industries is a large manufacturing conglomerate based in the United States with annualsales in excess of$300 million. Its shares are traded on the New York Stock Exchange, and have a marketcapitalization of nearly $750 million. Hatfield is currently under investigation by the Securities andExchange Commission (SEC) for accounting irregularities and possible legal violations in thepresentation of the company's financial statements. A due diligence team from the SEC has beensent to Hatfield's corporate headquarters in Philadelphia for a complete audit in order to furtherassess the situation.Several unique circumstances at Hatfield are discovered by the SEC due diligence team during thecourse of the investigation:Management has been involved in ongoing negotiations with the local labor union, of whichapproximately 40% of its full-time labor force are members. Labor officials are seeking increasedwages and pension benefits, both of which Hatfield's management states is not possible at this timedue to decreased profitability and a tight cash flow situation. Labor officials have accused Hatfield'smanagement of manipulating the company's financial statements in order to have a reason to notgrant any concessions during the course of negotiations.All new equipment obtained over the past several years has been established on Hatfield's booksas operating leases, although past acquisitions of similar equipment was nearly always classified ascapital leases. Financial statements of industry peers indicate that capital leases for this type ofequipment are the norm. The SEC wants Hatfield's management to provide justification for thisapparent deviation from \"normal\" accounting practices.Inventory on Hatfield's books has been steadily increasing for the past few years in comparison tosales growth. Management credits improved operating efficiencies in its production methods thathave contributed to boosts in overall production. The SEC is seeking evidence that Hatfield somehowmay have manipulated its inventory accounts.The SEC due diligence team is not necessarily searching for evidence of fraud, but possi blemanipulation of accounting standards for the purpose of misleading shareholders and otherinterested parties. Initial review of Hatfield's financial statements indicates that at a minimum,certain practices have resulted in low quality earnings.Question 1Labor officials believe that the management of Hatfield is attempting to understate its net incomein order to avoid making any concessions in the labor negotiations. Which of the following actionsis least likely to be employed by management in an attempt to avoid making concessions to theunion?A) Recognizing revenue at the time of delivery rather than when payment is received.B) Lowering the discount rate used in the valuation of the company's pension obligations.C) Lengthening the life of depreciable assets in order to lower the depreciation expense.Question 2Hatfield has begun recording all new equipment leases on its books as operating leases, a changefrom its consistent past use of capital leases. What is the most likely motivation behind Hatfield'schange in accounting methodology? Hatfield is attempting to:A) reduce its cost of goods sold and increase it profitability.B) improve its leverage ratios and reduce its perceived leverage.C) increase its operating margins relative to industry peers.Question 3The SEC due diligence team is searching for the reason behind Hatfield's inventory build-up relativeto its sales growth. One way to identify a deliberate manipulation of financial results by Hatfield isto search for:A) a delay in the recognition of expenses. 1 ______________________ ©2018 FK Partners Todos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

B) A decline in inventory turnover. C) receivables that are growing faster than sales.Question 4Which of the following findings is most likely to be an indicator of potential revenue quality issues? A) Large increases in trade receivables. B) Reduction in volatility of the ratio of revenue to cash collection. C) Lessor use of the operating lease classification.Question 5Which of the following is least likely to be an indicator of improper accounting to boost operatingperformance? A) Deferral of expenses by capitalizing. B) Classification of ordinary expenses as nonrecurring. C) Decreases in core operating margin accompanied by spikes in negative special items.Question 6 - 7George Edwards is a senior analyst with The Edge Group, an independent equity research firmspecializing in micro cap companies that have recently had an initial public offering, or are likely togo public within the next three years. Over the current market cycle, small company stocks havebeen the leading performers in the equity market, and micro cap money managers have had hugecash inflows due to their funds' strong performance. With an excess amount of cash and few goodinvestment opportunities due to the high valuations in the marketplace, fund managers have turnedto independent research firms like The Edge Group to help them discover new investment ideas.With a large number of mutual fund managers asking them for research reports, business at TheEdge Group is booming. To help handle the large amount of business, Edwards has hired two newjunior analysts, Paul Kelley and Rachael Schmidt. Both Kelley and Schmidt have degrees in finance,and came highly recommended to Edwards.In Kelley and Schmidt's orientation meeting, Edwards told them that what has made The EdgeGroup successful in delivering quality research to its clients is its willingness to dig into companyfinancial statements and not take the accounting numbers at face value. Every item in the financialstatements should be scrutinized and adjusted if necessary. Edwards tells the new analysts that ifthere is one lesson they should learn, it is that \"there is a difference between accounting reality andeconomic reality.\"For their first assignment, Edwards has asked the new analysts to put together a draft of a researchreport on Landesign, an architecture firm specializing in landscape design for municipalities,residential developments, and wealthy individuals. The firm also sells various kinds of stone andplastic products which are used in landscaping applications. Edwards tells the new analysts that hewill help put together the report, but he would like them to do a majority of the legwork.Since it was founded seven years ago, Landesign has grown at an annual rate exceeding 20%. Muchof the growth comes from Landesign's acquisitions of regional competitors. Edwards points out tothe analysts that Landesign used purchase method accounting. Kelley, looking to impress Edwardswith his knowledge, tells him that when one company acquires another, assets of both companiesare restated to fair market value, and that higher depreciation can lead to lower quality earnings.Not wanting to be outdone, Schmidt adds that liquidity measures such as the quick ratio and thecash ratio should improve as Landesign makes acquisitions.Kelley decides to review Landesign's 2004 financial statements and make notes about significantaccounting practices being used. His notes are shown in the exhibit below:Exhibit 1: Kelley's Notes on Landesign's Accounting Practices  The firm uses First In, First Out (FIFO) accounting. As a side note, the current inflation rate has remained relatively constant at an annual rate of 3%.  Equipment and office furniture are depreciated based on the 200% declining balance method.  Fixed assets (equipment) are generally assigned short useful life estimates.  The expected return on defined benefit pension plan assets is 2 to 3 percentage points below the long-term rate of return for similar assets. ______________________ 2 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

 Landesign reports deferred taxes of $350,000 for 2004, compared with $300,000 and $280,000 in deferred taxes for 2003 and 2002, respectively.Schmidt notices that the footnotes to Landesign's financial statements include a reference to anagreement to receive a minimum amount of stone used to construct landscape walls from a supplier.Under the terms of the agreement, Landesign will pay for the stone whether it is used in the currentaccounting period or not. The agreement allows Landesign to pay a price that is significantly lessthan the current market price for similar quality stone. A second footnote indicates that Landesignhas an eight-year rental commitment for a greenhouse used to grow plants and store mulch thatLandesign uses in the landscaping process. On the financial statements, $55,000 in rent expensefor the greenhouse is listed on the income statement. The footnote also states that the $55,000rental expense payment was agreed upon with Fred's Nursery, the owner of the greenhouse, basedupon an interest rate of 7%.A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for95% of their original value of $130,000. The footnote indicates that Landesign retains the risk ofnoncollection of the receivables.The final footnote on the page indicates that Landesign has a revolving line of credit at which it canborrow funds in the future at an interest rate of 6%.After going through the information, Kelley and Schmidt discuss their findings and start to work ontheir report for Edwards.Question 6Which of the following items noted in Kelley's Notes on Landesign's Accounting Practices would leastlikely be considered indicators of high earnings quality. Landesign's use of: A) the 200% declining balance method of depreciation on its furniture and equipment. B) short useful life estimates for fixed assets. C) FIFO accounting in a mildly inflationary economy.Question 7Which of the following adjustments should Schmidt make to Landesign's financial statements toaccount for the greenhouse that Landesign uses to grow plants and store mulch? A) Increase both liabilities and assets by $341,500. B) Increase liabilities and decrease equity by $440,000. C) Increase both liabilities and assets by $328,400. ______________________ 3 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

______________________ 4 ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio.

Answers – SS 06 - Financial Reporting and Analysis Quality of Financial Reports and Financial Statement AnalysisQuestions 1 - 5Questions 1The correct answer was C) Lengthening the life of depreciable assets in order to lower thedepreciation expense.It is unlikely that management would lengthen the life of depreciable assets in order to extractconcessions from the union, as lengthening the depreciable life of an asset would boost earningsresults.Question 2The correct answer was B) improve its leverage ratios and reduce its perceived leverage.Off balance-sheet financing through the use of operating leases is acceptable when usedappropriately. However, companies can use them too aggressively in order to reduce their perceivedleverage. A comparison among industry peers and their practices may indicate improper use ofaccounting methods.Question 3The correct answer was B) a decline in inventory turnover.A warning sign of accounting manipulation is abnormal inventory growth as compared to salesgrowth. By overstating inventory, the cost of goods sold is lower, leading to higher profitability.Question 4The correct answer was A) Large increases in trade receivables.Revenue quality issues may be indicated by large increases in accounts receivable or large decreasesin unearned revenue, an increase in the volatility of the ratio of revenue to cash collections, and bylessor use of capital leases.Question 5The correct answer was C) Decreases in core operating margin accompanied by spikes in negativespecial items.Classification of ordinary expenses as nonrecurring and deferral of expenses via capitalization wouldimprove reported operating margins as would increases in core operating margin accompanied byspikes in negative special items.Questions 6 - 7Question 6The correct answer was C) FIFO accounting in a mildly inflationary economy.High earnings quality is established by a clear and conservative approach to stating earnings. Eventhough inflation is relatively mild, FIFO accounting will result in lower cost of goods sold (COGS),and higher net income. This is more aggressive than the use of Last In, First Out (LIFO) method.Short useful lives for fixed assets, use of accelerated depreciation, and using a conservativeestimate for returns on pension assets will all tend to increase expenses and are examples ofconservative accounting practices.Question 7The correct answer was A) Increase both liabilities and assets by $341,500.The rental agreement for the greenhouse is an operating lease and essentially represents off-balance sheet financing. To adjust Landesign's balance sheet for the operating lease, Schmidt needsto capitalize the lease by increasing both liabilities and assets by the present value of the leasepayments. The interest rate used in the present value computation is the lower of the firm's financingrate or the rate implicit in the lease. We are told that the rental payments of $55,000 are based onan interest rate of 7%. However, we are told in another footnote that Landesign expects to be ableto borrow funds in the future at a rate of 6%. We therefore use the lower firm financing rate of 6%in our computation. The present value of the lease payments is: N = 8; I/Y = 6%; PMT = -55,000;FV = 0; CPT PV = $341,539. _________________________ ©2018 FK PartnersTodos os direitos reservados – É proibida a reprodução total ou parcial, de qualquer forma ou por qualquer meio 1











LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Example: Expansion Project New equipment:  Cost $450 million  Depreciated straight-line to $0 over three years  Working capital increase of $25 million  Can be sold in three years for $50 million  Paid outside consultant $2 million for detailed market share and cost analysis (cont.)© Kaplan, Inc. 8LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Solution: Expansion ProjectStep 1: Calculate the initial outlay Outlay = $450 + $25 = $475 Initial cost of asset Increase in Working© Kaplan, Inc. Capital 10 ©2018 FK Partne

SS 07 - Corporate FinanceLOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Example: Expansion Project More data:  Incremental revenue of $400 MM each year  Annual cash operating expense of $200 MM  Cost of capital is 20%  Marginal tax rate is 40% Calculate: NPV and IRR and determine appropriate investment decision© Kaplan, Inc. 9LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Solution: Expansion Project Step 2: Calculate the operating cash flow for each year of the project(Revenues – expense)(1 – T) Depreciation tax shield CF = ($400 – $200)(1 – 0.4) + (0.4)($150) = $120 + $60 = $180 Depreciation = $450/3 = $150© Kaplan, Inc. 11ers - Exame CFA 3

LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Solution: Expansion ProjectStep 3: Calculate the terminal cash effects TNOCF = $50 + $25 – 0.4($50 – $0) = $50 + $25 – $20 = $55 Sale of Tax on sale of asset asset Recapture of working capital© Kaplan, Inc. 12LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 CFs for a Replacement Project Differences:  Sale of old: Reduce the initial outlay by the after- tax proceeds from the sale (t = 0)  Depreciation: Use only the difference between old and new depreciation  Operating CFs: Consider only incremental cash flows from new project  Terminal CFs: Salvage and tax are the difference between the new machine and what would have been received if the old machine had been kept© Kaplan, Inc. 14 ©2018 FK Partne

SS 07 - Corporate FinanceLOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Solution: Expansion Project Year CFs 0 –$475 1–2 $180 3 $235NPV: –$64 IRR: 11.6%Reject: NPV < 0 and IRR < 20%© Kaplan, Inc. 13LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Example: Replacement ProjectMilwaukee Mfg. is considering purchasing a new laserlathe. The new lathe will cost $400,000 and will replacean existing lathe. While the revenues will be unchanged,cost savings of $120,000 per year for five years areexpected to be realized from the new lathe. The fullydepreciated old lathe can be sold today for $100,000 butcan be used for five more years—at which point it will beworthless. The new lathe will be depreciated straight lineto zero salvage over five years. The new lathe ishowever expected to sell for $50,000 after five years.The tax rate is 40% and required rate of return = 12%.© Kaplan, Inc. 15ers - Exame CFA 4

LOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Solution: Replacement ProjectYear 0 incremental cash outflow:Cost of new lathe – after-tax salvage value of old lathe = 400,000 – (100,000 – 40,000) = $340,000Years 1-5 incremental cash flow:AT cost savings + incremental depreciation tax shield = 120,000(1 – 0.40) + (80,000-0)(0.4) = $104,000© Kaplan, Inc. 16LOS 21.c Evaluate Capital BudgetingSchweser B2 pg 171, CFAI V3 pg 38 Projects With Unequal Lives Situation: Two mutually exclusive projects with different lives (details of CFs omitted) and projects replaced repeatedly Project cost of capital = 12%  NPV of book press with 6-year life = $3,245  NPV of offset printer with 3-year life = $2,577 Point: The 6-year may not be better  Takes longer to generate the higher NPV© Kaplan, Inc. 18 ©2018 FK Partne

SS 07 - Corporate FinanceLOS 21.a Calculate/Evaluate Capital BudgetingSchweser B2 pg 163, CFAI V3 pg 27 Solution: Replacement ProjectYear 5 Terminal cash flow:ATSV of new lathe – ATSV of old lathe + NWCInv = 50,000(1 – 0.40) – 0 + 0 = $30,000NPV @ 12% = $51,919.53© Kaplan, Inc. 17LOS 21.c Evaluate Capital BudgetingSchweser B2 pg 171, CFAI V3 pg 38 Least Common Multiple of Lives T0 T1 T2 T3 T4 T5 T6 –10,000 3,500 6,500 6,000 3,500 6,500 6,000OR 2,577 –10,000 Replacement at –4,000 end of Year 3 2,577 Combined NPV of two offset printer: One today and one in three years: NPVchained printers @ 12% = $4,412; IRR = 25.2% 19© Kaplan, Inc.ers - Exame CFA 5

LOS 21.c Evaluate Capital BudgetingSchweser B2 pg 171, CFAI V3 pg 38Least Common Multiple of Lives Method NPVs can now be directly compared Press (6-year project): NPV = $3,245 Printer (6-year replacement): NPV = $4,412 Decision: Select the higher (equal-life) NPV© Kaplan, Inc. 20LOS 21.c Evaluate Capital BudgetingSchweser B2 pg 171, CFAI V3 pg 38 Capital Rationing Point: Allocate fixed capital to maximize shareholder wealth How?: Choose the combination of projects that has the highest total NPV Rank projects using profitability index 1+ NPV Outlay© Kaplan, Inc. 22 ©2018 FK Partne

SS 07 - Corporate FinanceLOS 21.c Evaluate Capital BudgetingSchweser B2 pg 171, CFAI V3 pg 38 Equivalent Annual Annuity (EAA) EAA: Annual payment equivalent for each NPV:  6-year book press PV = –3,245; N = 6; I = 12;  PMT = $789 Which would you rather have?  3-year offset print PV = –2,577; N = 3; I = 12;  PMT = $1,073  Decision: Select the project with the higher EAA© Kaplan, Inc. 21LOS 21.c Evaluate Capital BudgetingSchweser B2 pg 171, CFAI V3 pg 38 Capital Rationing: Example Omni Corporation has a $3,000 capital budget Project A Investment NPV Profitability Project B Outlay Index Project C –1,650 $700 1.42 Project D –1,400 $670 1.48 Project E –1,100 $400 1.36 –600 $200 1.33 –300 1.20 $60 Highest NPV total = $670 + $400 + $60 = $1,130 Capital budget = 1,400 + 1,100 + 300 = $2,800 < $3,000© Kaplan, Inc. 23ers - Exame CFA 6