Free CFA Level II Corporate Issuers Practice Questions
Corporate issuers on the CFA Level II exam tests capital budgeting under uncertainty, capital structure theory (Modigliani-Miller), dividend policy, mergers and acquisitions, and corporate governance practices. Weighted 5-10% (CFA Institute).
Sample Questions
Question 1
Easy
The Hamada equation is most commonly used to:
Solution
C is correct.
The Hamada equation relates a firm's leveraged (equity) beta to its unleveraged (asset) beta:
where is the leveraged beta, is the unleveraged beta, is the marginal tax rate, and 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.
The Hamada equation relates a firm's leveraged (equity) beta to its unleveraged (asset) beta:
where is the leveraged beta, is the unleveraged beta, is the marginal tax rate, and 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.
Question 2
Medium
Which of the following best describes the bootstrap effect in a stock-for-stock acquisition?
Solution
A 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.
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.
Question 3
Hard
Based on the information provided about Meridian Industries, the company's WACC is closest to:
Solution
B is correct.
First, compute the cost of equity using CAPM:
The cost of preferred stock equals its dividend yield. Since preferred trades at par, .
Calculate WACC using the target capital structure:
First, compute the cost of equity using CAPM:
The cost of preferred stock equals its dividend yield. Since preferred trades at par, .
Calculate WACC using the target capital structure: