PART I

You should spend approximately 15 minutes on Part I. Read the following extract from a text on transfer pricing, and the questions following the extract. Identify the best option as the answer to each question on the basis of what you have read in the extract. For each question, mark ONE letter (A,B or C) as the correct answer.

Extract – Market-Based Transfer Prices

In most circumstances, where a perfectly competitive market for an intermediate product exists, it is optimal for both decision-making and performance evaluation purposes to set transfer prices at competitive market prices. A perfectly competitive market exists where the product is homogenous and no individual buyer or seller can affect the market prices.

When transfers are recorded at market prices divisional performance is more likely to represent the real economic contribution of the division to total company profits. If the supplying division did not exist, the intermediate product would have to be purchased on the outside market at the current market price. Alternatively, if the receiving division did not exist, the intermediate product would have to be sold on the outside market at the current market price. Divisional profits are therefore likely to be similar to the profits that would be calculated if the divisions were separate organizations. Consequently, divisional profitability can be compared directly with the profitability of similar companies operating in the same type of business.

In a perfectly competitive market the supplying division would supply as much as the receiving division requires at the current market price, as long as the incremental cost is lower than the market price. If this supply is insufficient to meet the receiving division’s demand, it must obtain additional supplies by purchasing them from an outside supplier at the current market price. Alternatively, if the supplying division produces more the intermediate product than the receiving division requires, the excess can be sold on the outside market at the current market price.

If the supplying division cannot make a profit in the long run at the current outside market price then the company will be better off not to produce the product internally but to obtain its supply from the external market. Similarly, if the receiving division cannot make a long-run profit when transfer are made at the current market price, it should cease processing this product, and the supplying division should be allowed to sell its output to the external market. Where there is a competitive market for the intermediate product, the market price can be used to allow the decisions of the supplying and receiving divisions to be made independently of each other.

In practice, it is likely that total company profits will be different when the intermediate product is acquired internally or externally. The supplying division will incur selling expenses when selling the intermediate product on the external market, but such expenses will not be incurred in inter-divisional transfers. If the transfer price is set at the current market price, the receiving division will be indifferent as to whether the intermediate product is obtained internally or externally. However, if the receiving division purchases the intermediate product externally, the company will be worse off to the extent of the selling expenses incurred by the supplying division in disposing of its output on the external market. In practice, many companies modify the market price rule for pricing inter-divisional transfers and deduct a margin to take account of the savings in selling and collection expenses.

By Colin Drury, from Management Accounting for Business Decisions. Second edition 2003, Thomson Learning.

1. Where it is operating in a perfectly competitive market a transfer price should be set which

2. Where an organization has a division that supplies items to another division, setting the transfer price at market price will

3. If the supplying division cannot meet all of the receiving division's demand for the product when the transfer price is the current market price, what will happen?

4. A receiving division which cannot operate profitably long-term when the transfer price is the market price should

5. If a company purchases externally rather than internally at the current market price, its profits will decrease because

PART II

You should spend approximately 15 minutes on Part II. Whilst the CFA exam is less focused on calculations than many people expect, it is important at the start of the learning process to be confident in performing basic financial math computations and to know how to use your calculator effectively. All of the content in the questions below is covered during the SHP Financial Training Level I CFA Prep Course. Remember that only the HP12C or Texas BAII Plus calculators are allowed in the exam. Work through the following questions and for each question, mark ONE letter (A,B or C) as the correct answer.

1. Suppose you will receive R$1,000 ten years from today and that the appropriate annualized discount rate is 10%. Compute the present value of this cash flow assuming semi-annual compounding 2. You bought a 9%, semi-annual, 8-year corporate bond with a par value of R$1,000 (par value represents the terminal value of the bond). Compute the value of this bond today if the appropriate discount rate is 8%. The 9% is the coupon rate of the bond and represents the annual cash flow associated with the bond.

3. You borrow R$250,000, to be repaid in equal annual instalments over 20 years. Repayments are at the end of each year. The interest rate is 4%. What are the annual repayments? 4. An investor opens a fund with an investment of R$500,000. At the end of the first year, the investor
withdraws £25,000, leaving a balance of £560,000. What is the holding period return?

5. An analyst is observing investment returns across a class of hedge funds. He observes a sample of 6 results, as follows: 3%, 3.2%, 2.9%, 4.2%, 1.2%, -4%. What is the arithmetic mean of the sample?

6. An investment has a stated return of 8%. What is the semi-annual effective rate?

7. What is the fourth root of 28,561?

8. An investment costs R$100 today. It generates returns of R$50 for the next four years and then R$60 for two years after that. What is the NPV of these cash flows based on a discount rate of 10%? 9. What is the IRR of the cash flows in question 8? 10. What is the intrinsic value of an irredeemable preference share that pays a 5.75% coupon on a par value of R$10. The risk free rate of interest is 3% and investors require an additional return of 4%
over this to compensate for the additional risk involved with this investment