Absolute Free CFA-Level-II Exam Practice for Comprehensive Preparation 

At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18

In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.

In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:
Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.
Statement 2: A high E/P implies the security is overpriced.
Assuming that the cost of equity for FDS does not change, the present value of growth opportunities in the share price following the announcement that the company would be expanding its retail operations, using Emery's 2009 earnings forecast, is closest to:

James Kelley is the CFO of X-Sport Inc., a manufacturer of high-end outdoor sporting equipment. Using both debt and equity, X-Sport has been acquiring small competitor companies rather rapidly over the past few years, leading Kelley to believe that the firm's capital structure may have drifted from its optimal mix. Kelley has been asked by the board of directors to evaluate the situation and provide a presentation that includes details of the firm's capita! structure as well as a risk assessment. In order to assist with his analysis, Kelley has collected information on the current financial situation of X-Sport. He has also projected the financial information for alternative financing plans. This information is presented in Exhibit 1.

After carefully analyzing the data, Kelley writes his analysis and proposal and submits the report to Richard Haywood, the chairman and CEO of X-Sport Inc. Excerpts from the analysis and proposal follow:
* In selecting a re-financing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current Baa rating, causing our cost of debt to rise dramatically. This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest tax shield will be more than The marginal increase in the costs of financial distress. However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of X-Sport management with its shareholders.
* In the event that X-Sport decides to proceed with a recapitalization plan, I recommend Plan D since it is the most consistent with the shareholders' interests.
Haywood reviews the report and calls Kelley into his office to discuss the proposal. Haywood suggests that Flan B would be the most appropriate choice for adjusting X-Sport's capital structure. Before Kelley can argue, however, the two are interrupted by a previously scheduled meeting with a supplier.
Haywood takes Kelley's data and proposes to the board of directors that X-Sport pursue one of three alternatives to restructure the company. The first alternative is Plan B from Kelley's analysis. The second alternative involves separating GearTech, one of the companies acquired over the last few years, from the rest of the company by issuing new GearTech shares to X-Sport common shareholders. The third alternative involves creating a new company, Euro-Sport, out of the firm's European operations and selling 35% of the new Euro-Sport shares to the public while retaining 65% of the shares within X-Sport. After some persuading, Haywood convinces the seven-member board (two of whom were former executives at GearTech) to accept the second alternative, which he had favored from the beginning. The board puts together an announcement to its shareholders as well as the general public, detailing the terms and goals of the plan.
A group of shareholders, upset about the board's plan, submit a formal objection to X-Sport's board as well as to the SEC. In the objection, the shareholders state that the independence of the board has been compromised to the detriment of the company and its shareholders. The objection also states that:
* The value of X-Sport's common stock has been impaired as a result of the poor corporate governance system.
* The liability risk of X-Sport has increased due to the increased possibility of future transactions that benefit X-Sport's directors, without regard to the long-term interests of shareholders.
* The asset risk of X-Sport has increased due to the inability of investors to trust the GearTech financial disclosures necessary to value the division.
Which of the following best explains the difference between X-Sport's current cost of debt and the cost of debt associated with Plan A?

Holbrook calculates the NPV of the robotic project and presents his findings to his supervisor, Geoffrey Mans. After reviewing the report, Mans makes the following recommendations:
1 'You forgot to include the $ 100,000 we have spent so far on consultants and project engineers and who knows what else to evaluate the project's feasibility. Rerun the numbers including that amount and get the revised calculations to me this afternoon.'
2. 'Rerun the analysis assuming straight-line depreciation for tax purposes. The NPV will be higher, and we'll be more likely to get the project funded.'
Cummings has two other projects under consideration that would affect the production of storage lockers. Project 1 relates to changing the production process, and Project 2 relates to expanding the distribution facility. Holbrook estimates the NPV of the expected cash flows for Project 1 at negative $7 million. An additional investment of $3 million would allow management to more rapidly adjust to the demand for a certain type of locker. The value of this flexibility is estimated at $9 million. He estimates that the NPV of the expected cash flows for Project 2 at $3 million. An expansion option would require an additional investment of $2 million. At this time, Cummings does not have any capital rationing restrictions.
Holbrook emails the lead analyst for the budgeting group and indicates that he cannot make a decision on Project 2 without knowing the value the expansion option will provide.
Holbrook calls a capital budgeting meeting with CEI's production manager and quality control manager. Holbrook opens the meeting by stating: 'I think we should accept this project based solely on the fact that it provides great operating margins. Nevertheless, I think we should conduct net present value (NPV) analysis to confirm my opinion.' Holbrook then receives the following comments:
Comment 1:
It is important that interest is included in the discounted cash flows used with NPV analysis because interest is a real and very significant expense.
Comment 2:
If applied correctly, the NPV of this project will be higher if we discount economic profits instead of net after-tax operating cash flows in our analysis. I suggest we calculate economic profit as net operating profit after tax minus the dollar cost of capital.
The economic income for year 3 for the robotics project from Exhibit 1 is closest to:

Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.

Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.
Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios. Three of the advantages of P/B ratios that Aims recalls are:
Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.
Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.
Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.
Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, 'I could do this fairly easily)
If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio.'
Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.
Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.
Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA .
Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.
Is Aims correct in describing how we could transform a justified P/E ratio into a P/S ratio or a P/B ratio?