Free CFA Level II Corporate Issuers Practice Questions

C is correct. The Hamada equation relates a firm's leveraged (equity) beta to its unleveraged (asset) beta:
$$\beta_L = \beta_U \left[1 + (1 - t)\frac{D}{E}\right]$$
where $\beta_L$ is the leveraged beta, $\beta_U$ is the unleveraged beta, $t$ is the marginal tax rate, and $D/E$ is the debt-to-equity ratio. This equation is particularly useful in the pure-play method for estimating project-specific betas: unlever a comparable company's beta and relever it to the subject company's capital structure.

B is incorrect. The Hamada equation shows how leverage affects beta (and thus cost of equity), but it does not directly calculate the optimal capital structure. Finding the optimal structure requires analyzing the tradeoff between the tax shield benefit and financial distress costs across different leverage levels.

A is incorrect. Break points in the marginal cost of capital schedule are calculated by dividing the amount of capital at which the cost of a component changes by the weight of that component in the capital structure. The Hamada equation has no role in this calculation.

C is correct. The bootstrap effect (or bootstrap earnings) occurs in a stock-for-stock acquisition when the acquiring company has a higher P/E ratio than the target. Because the acquirer pays fewer shares (relative to its earnings power) for each dollar of the target's earnings, the combined entity's EPS increases even without any real synergies or value creation. This is an accounting illusion — total earnings increase, but shares outstanding also increase by a smaller proportionate amount. The market should not reward this artificial EPS increase with a higher share price if no real value is created.

B is incorrect. The bootstrap effect is about EPS accretion from P/E differentials, not about diversification reducing the cost of capital. The conglomerate discount literature actually suggests diversification through acquisition often does not reduce cost of capital.

A is incorrect. The bootstrap effect does not describe synergy-driven price increases. It specifically refers to the mechanical EPS increase from acquiring a lower P/E company, regardless of synergies.

B is correct. First, compute the cost of equity using CAPM:
$$r_e = r_f + \beta \times ERP = 3.5\% + 1.15 \times 6.7\% = 3.5\% + 7.705\% = 11.205\%$$

The cost of preferred stock equals its dividend yield. Since preferred trades at par, $r_p = 6.5\%$.

Calculate WACC using the target capital structure:
$$WACC = w_d \times r_d(1-t) + w_p \times r_p + w_e \times r_e$$
$$WACC = 0.35 \times 0.058 \times (1 - 0.25) + 0.05 \times 0.065 + 0.60 \times 0.11205$$
$$= 0.35 \times 0.0435 + 0.00325 + 0.06723$$
$$= 0.015225 + 0.00325 + 0.06723 = 0.08571 \approx 8.57\%$$

A is incorrect (9.08%). This results from using the pre-tax cost of debt without the tax adjustment: $0.35 \times 0.058 + 0.05 \times 0.065 + 0.60 \times 0.11205 = 0.0203 + 0.00325 + 0.06723 = 0.09078$.

A is incorrect (9.72%). This results from omitting the preferred stock component and overweighting equity: $0.35 \times 0.058 + 0.65 \times 0.11205 = 0.0203 + 0.07283 = 0.09313$, then rounding up, or from a similar structural error in weighting.