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May212017|
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Introduction
PortfolioManagementIndividualRichards
Totalscore:1outof6,17%
QuestionFeedback
Block1:TOS
Question
1of1
Byaccessingthisassessment,youagreetothefollowingtermsofuse:Thepracticetestsandmockexamsare
providedtocurrentlyregisteredCFAcandidates.Candidatesmayviewandprinttheexamsforpersonalexam
preparationonly.Thefollowingactivitiesarestrictlyprohibitedandmayresultindisciplinaryand/orlegalaction:
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anywebsite,emailing,distributing,and/orreprintingthepracticetestsandmockexamsforanypurpose.
Iagree.
0outof0
Block2:PortfolioManagementIndividualRichards
Question
1of6
UsingtheplanningframeworkthatRichardssuggests,whichperson'sestimateoftheaftertaxprimarycapitalis
mostaccurate?
Richards
Boshe
Adams
0outof1
EdvardRichardsispresidentandsoleownerofMoreThanLumberCorporation(MTL),aprivatelyheldbuildingmaterials
company.FoundedbytheRichardsfamily,thecompanyhasbeenrunbyEdvardRichardsformorethan40years.
RichardsalsoownsinvestmentrealestateintheformofawarehouseunrelatedtoMTL,aswellas70,000common
sharesofpubliclytradedCintas(CTAS)thatheinherited.Hewantsthesetwoitemstobeconsideredconcentrated
positions.
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Now68,Richardsisseekingadviceonhowtotransitiontoretirement.Heprovidesinformationabouthisholdings,
showninExhibit1,totwocompetingfinancialadvisers,ToddAdamsandLindaBoshe.
Exhibit1
RichardssValues
CostBasis
EstimatedValue
Asset
($thousands)
($thousands)
TaxRates
Capitalgainstaxrate=20% Incometaxrate=40%
Richardsaskseachadvisertoapplyagoalbasedplanningframeworkhehasreadaboutthatusesthreeriskbuckets:
personal,market,andaspirational.Asafirststep,heestimateshisownaftertaxprimarycapitalassumingthatall
assetsaresoldtodayandconvertedintocash.Heasksthetwoadviserstoassesshisaftertaxprimarycapitalunder
thesameassumptions(allthreeestimatesareprovidedinExhibit2).
Exhibit2
EstimatesofAfterTaxPrimaryCapital
($thousands)
Richards 11,780
Adams 8,380
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Boshe 11,640
RichardswantstomonetizeandeliminatetheconcentrationriskofhisCTASholdingwithoutpayingtaxesoncapital
gainsandtheninvesttheproceedsinabalancedportfolio.Henotesthefollowingcommentsinhisdiscussionswiththe
twoadvisers:
Richards:MybrokersayshecanarrangeacashlesscollaragainstCTASorashortsaleagainstthebox.I
understandthatbothmethodswillavoidincurringanimmediatecapitalgainandbothwillexposemeto
thesamelevelofmarketrisk.Icanborrowagainstthepositioninbothcasesandoffsetthecostof
borrowingwiththeCTASdividends.
Adams:Wecouldhelpyoucompleteashortagainsttheboxtransaction.Thisstrategywillprovideahighloan
tovalue(LTV)ratioandavoidcounterpartyrisk.Atotalreturnequityswaphasthesesameadvantages.
YoucanthusrealizetheeconomicgainonCTASwhiledeferringcapitalgainstaxes.
Boshe:Wesuggesteitheraforwardconversionwithoptionsoranequityforwardsale.Eitherwillachievehigh
LTVratiomonetizationwithoutincurringimmediatecapitalgainstaxes,andbothmethodsavoid
counterpartyrisk.
AdamshasstrongconnectionstotherealestatemarketandinformsRichardsthatthemarketvalueestimateof$3
millionforthewarehouseismuchtoolow.HeadvisesRichardstoconsiderreducinghisrealestateriskdirectlyby
usingtheimmediatecashinflowsnetoftaxliabilitiesandcoststoincreasehisstockandbondportfolios.Adamsis
confidenthecanarrangeanyofthefollowingrealestateoffers:
1.Sellthewarehousefor$4.8milliontoanoutsideinvestor.
2.Enterintoarecoursemortgageloan,withthewarehousevaluedat$5.8millionbythelenderandanLTVratioof
80%.
3.Enterintoasaleandleaseback,withthewarehousevaluedat$4.9millionandthefirstyearsrentalpaymentof
$150,000payableatthestartofthelease.
Boshehasstrongconnectionstotheinvestmentbankingcommunity.Richardshasauthorizedhertoascertainthelevel
ofinterestforthesaleofMTL.Bosheisconfidentshecanarrangeanyofthefollowingstrategies:
MTLStrategy1:AprivateequityfirmcanarrangetoleverageMTL,payingRichards40%ofhisestimatedvalueofMTL
(asshowninExhibit1)incashupfrontandrollingtheremaining60%ofthevalueintonewsharesthatpayno
dividends.Richardswillstayonaspresidentforfiveyears,duringwhichtimehewillhelptransitionleadershipto
anewteam.Afterfiveyears,hewillsellormonetizetheremainingownership.
MTLStrategy2:Asmallbutrapidlygrowingpubliclytradedbuildingmaterialscompanyiswillingtoacquire100%
ownershipandpayRichards$7millionincashupfrontandemployeestockoptionsthathecanexerciseafter
twoyearsandthatexpireinfiveyears.Thepubliccompanyistoosmalltosupportpubliclytradedstockoptions.
Shouldthepubliccompanysstockrise,Richardscanexercisehisemployeestockoptions,whichwillbetaxed
asordinaryincome.Toprotectthevalueofhisappreciatedstockwhileparticipatinginfurtherupsidepotential,he
canpurchaselongtermprotectiveputoptionsonanindustryexchangetradedfund(ETF)thatcloselytracksthe
buildingmaterialsindustry.Ifthepubliccompanysstocksubsequentlydropsalongwiththeindustry,hecansell
theputs.
MTLStrategy3:Createanemployeestockownershipplan(ESOP)thatwouldborrowsufficientfundstopurchase40%
ofRichardssownership.Richardswouldmaintainupsidepotentialinhisretainedshares,whichcouldbesoldat
somepointinthefuture.
Incorrect.
Primarycapitalisthesumofassetsthatfallintothepersonalandmarketriskbuckets.Itincludestheresidence,
municipalbondportfolio,globalequityfundandcashequivalents.ItexcludesthevaluesofMTLandthe
concentratedpositionsinCTASpublicstockandthewarehouse(investmentrealestate)thoseareconsidered
aspirational.
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Adamshasthecorrectvalue.
CFALevelIII
"ConcentratedSingleAssetPositions,"ThomasJ.BoczarandNischalR.Pai
Section3
Question
2of6
Richards'sunderstandingaboutmonetizingCTASismostaccuratewithrespectto:
usingtheCTASdividendstooffsetborrowingcosts.
avoidingimmediatecapitalgainsunderbothstrategies.
theriskexposureofbothstrategies.
0outof1
Incorrect.
Richards'sunderstandingaboutavoidingimmediatecapitalgainsiscorrect.Theshortsaleagainsttheboxapproach
deferscapitalgains.Nosaleofstockoccursinestablishingthecollar.Theshortagainsttheboxstrategyisriskless
whereasthecollardoescarryriskwithintherangebetweentheexercisepricesoftheputandthecall.The
dividendswillcontinuetobepaidtoRichardsonlyinthecollar.Thedividendswillpassthroughtothelenderofthe
sharesthatwereborrowedintheshortagainsttheboxstrategyandthusnotavailabletoRichards.
CFALevelIII
"ConcentratedSingleAssetPositions,"ThomasJ.BoczarandNischalR.Pai
Section4.3
Question
3of6
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WhichofAdams'sandBoshe'scommentsaboutcounterpartyriskismostaccurate?Thecommentmadeby:
Bosheaboutherproposedstrategies.
Adamsabouttheshortsaleagainstthebox.
Adamsaboutthetotalreturnequityswap.
1outof1
Correct.
Adams'sstatementabouttheshortsaleagainsttheboxiscorrectbecauseitcreatesarisklessposition.Although
theforwardconversionwithoptionsavoidscounterpartyrisk,theequityforwardsaleandthetotalreturnequity
swapuseaderivativesdealerandthusincludecounterpartyrisk.
CFALevelIII
"ConcentratedSingleAssetPositions,"ThomasJ.Boczar,andNischalR.Pai
Section4.2,4.3
Question
4of6
UsingtheinformationinExhibit1andAdams'srealestateproposals,whichofferwillprovidethelargest
immediateadditionoffundstoRichards'sstockandbondportfolios?
Offer1
Offer3
Offer2
Questionnotanswered
ImmediatecashinflowsavailablewouldincludeproceedsandthepossiblefirstrentalpaymentinOffer2allcash
flowsarenetoftaxes.AsshowninthetablebelowOffer1,sellingthewarehouseoutright,producesthehighest
immediatecashflownetoftaxes:
Incometax
Offer Offer Cost TaxesPaid Loan Initial deduction NetTo
Amount GainsTaxes Proceeds Lease onrent Reinvest
=20% LTV=80% Payment IncomeTax Offerlessall
rate=40% taxes
1 4,800,000 4,300,000 (100,000) 4,700,000
2 5,800,000 4,300,000 0asnosale 4,640,000 4,640,000
occurs
3 4,900,000 4,300,000 (120,000) (150,000) 60,000 4,690,000
CFALevelIII
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"ConcentratedSingleAssetPositions,"ThomasJ.Boczar,andNischalR.Pai
Section6
Question
5of6
WhichofBoshe'sMTLstrategiesleastlikelydescribesastagedexitstrategy?
MTLStrategy2
MTLStrategy3
MTLStrategy1
Questionnotanswered
MTLStrategy2isnotastagedexitstrategybecauseitdoesnotprovidefortwospecificliquidityevents:cashup
frontandasaleormonetizationoftheremainderofRichards'sownershipinthefuture.Strategies1and3are
stagedexitstrategiesthatprovidefortwoliquidityevents.
CFALevelIII
"ConcentratedSingleAssetPositions,"ThomasJ.Boczar,andNischalR.Pai
Section4.3
Question
6of6
WhichofthefollowingstatementsaboutBoshe'sproposedexitstrategiesfromMTLismostaccurate?
MTLstrategy3exhibitsamismatchincharacter.
MTLstrategy2exhibitscrosshedging.
MTLstrategy2providesforthepossibilityofyieldenhancement.
Questionnotanswered
EvidenceofbothcrosshedgingandamismatchincharacterispresentinMTLStrategy2.Buyingputoptionson
theETFisacrosshedgeagainsttheindustryriskfacedbythepubliccompany.Thescenariooutlinesanexercise
ofemployeestockoptions,whichwillbetaxedasordinaryincome,andaneventualprofitfromaputoption,which
willbetaxedasacapitalgain.Thisdifferenceintaxtypeisamismatchincharacter.
CFALevelIII
"ConcentratedSingleAssetPositions,"ThomasJ.Boczar,andNischalR.Pai
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Section4
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