39 Free CFA Level 2 Practice Exams Questions and Answers on Equity Investments

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P/Es are high at the bottom of the cycle (due to lower EPS) and vice-versa at the top

• Build-up model
• Equity value =
• Cyclicality in P/Es
• Fair market value

10 year U.S. bond yield + (local inflation - U.S. inflation)

• risk free rate estimation in foreign country
• Life-cycle of a typical industry
• Residual income (or economic profit)
• Residual income model

- estimates the value of firm equity as the FV of its assets - liabilities- generally not used for going concerns- firms with minimal profits, or banks, or natural resource firms

• Asset based approach
• Equity value =
• Build-up model
• Market value

- no dividend histories- negative FCF- transparent reporting and high quality earnings

• Advantages of residual income model
• Fama-French model
• Build-up model
• Residual income model

- Most often used for tax purposes in U.S.- cash price characterized by a hypothetical willing & able buyer & seller- arm's length transaction- well-informed buyer and seller

• Equity value =
• FCFF vs. FCFE
• Market value
• Fair market value

= MV of common stock + MV of preferred equity + MV of debt + minority interest - cash & investments

• Enterprise Value (EV)
• Equity value =
• Market value
• Fair market value

1. differences in accounting methods2. different cultures3. different risk4. different growth opportunities

• Fair value for financial reporting
• Using relative valuation methods in an international context is challenging due to
• risk free rate estimation in foreign country
• Combining nominal and real valuation approach in an inflation scenario

- No dividends or div's don't match the earnings- firms with FCF that corresponds with their profitability- valuation perspective is that of a controlling shareholder

• FCFF model is appropriate when
• Asset based approach
• Dividend discount model is appropriate when
• A&D of P/S ratio

Pioneer --> Growth --> Mature --> Decline

• Life-cycle of a typical industry
• A&D of P/S ratio
• Cyclicality in P/Es
• A&D of P/B ratio

A: meaningful distressed firms or startups; hard to manipulate; not as volatile as P/ED: high growth doesn't necessarily mean high earnings/cash flow; does not capture differences in cost structure

• A&D of P/S ratio
• A&D P/CF ratio
• A&D of EV / EBITDA
• A&D of P/B ratio

- capitalize and amortize R&D and add them back to earnings for NOPAT- add back charges on strategic investments that will generate returns in the future- capitalize (but don't amortize) goodwill, add amortization expense back to NOPAT and accumulated A back to invested capital- consider only cash taxes (add back deferred)- capitalize operating leases- add LIFO reserve to IC and the change to NOPAT

• Using relative valuation methods in an international context is challenging due to
• Adjustments before calculating NOPAT and invested capital in the residual income valuation method
• Advantages of residual income model
• Disadvantages of residual income model

- terminal value does not dominate- data easy to find- applicable to firms who do not pay dividends or expect positive FCF in the short fun- focuses on economic profitability

• Fama-French model
• Disadvantages of residual income model
• Advantages of residual income model
• Residual income model

1. country risks are diversification2. companies respond differently to country risk3. country risk is one-sided4. identifying cash flow effects aids in risk mgmt

• Four definitions of CF used in P/CF ratio
• Lower persistence factors are associated with
• Higher persistence factors are associated with
• Four arguments supporting adjustments to cash flow rather than the discount rate (for international companies)

- prior acquisition (for public & private firms) values include control premiums- financial vs. strategic buyer

• Normalized earnings should
• Guideline Public Company Method
• Residual income model
• Guideline Transactions Method

A: more useful if firms have different degrees of financial leverage; useful for capital-intensive business (lots of D&A); usually positive even if EPS is notD: if WCInv is growing, EBITDA will overstate CFO; doesn't capture different revenue recognition policies affecting CFO; EBITDA doesn't capture CAPEX

• A&D of P/B ratio
• A&D P/CF ratio
• A&D of P/S ratio
• A&D of EV / EBITDA