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CFA Level II Updated
How does the flow-to-equity method value just the equity portion, and when is it preferred over WACC or APV?
The FTE method discounts cash flows to equity holders (after debt service and taxes) at the levered cost of equity. It directly values equity without computing total firm value first. All three methods (WACC, APV, FTE) yield identical results under consistent assumptions.
Why does the LASSO's L1 penalty produce sparse models by setting some coefficients exactly to zero?
LASSO's L1 penalty creates sparsity because its diamond-shaped constraint region has corners on the coordinate axes. The OLS solution frequently contacts these corners, forcing some coefficients to exactly zero and producing automatic variable selection.
What is the productivity paradox, and why hasn't the digital revolution produced the expected surge in measured productivity?
The productivity paradox describes the disconnect between massive technology investment and disappointing measured productivity growth. Leading explanations include GDP mismeasurement of digital goods, long implementation lags for general-purpose technologies, redistribution rather than creation effects, and the structural shift toward low-productivity services.
How do you construct a zero-cost collar, and what trade-offs does the 'free' hedge involve?
A zero-cost collar buys a protective put and sells a covered call with matching premiums, creating downside protection at no cash cost. The trade-off is capped upside — you sacrifice gains above the call strike to fund the put protection.
When is it optimal to exercise an American call option early due to dividends, and how do you decide?
Early exercise of an American call is optimal just before an ex-dividend date when the dividend exceeds the remaining time value of the option. The time value comprises interest savings from deferring strike payment and the embedded put value.
What are PIK (Pay-in-Kind) bonds and why are they considered high-risk instruments?
PIK bonds pay interest by issuing additional bonds rather than cash, causing the principal to compound. They are considered high-risk because credit exposure grows annually, they signal potential cash flow weakness, and they are typically deeply subordinated.
How does arbitrage work with depositary receipts, and what keeps ADR prices aligned with the underlying shares?
Depositary receipts stay aligned with underlying foreign shares through an arbitrage mechanism where traders buy cheap shares in one market and sell the equivalent in the other, pocketing the difference. Time zone gaps, transaction costs, and capital controls create frictions.
How do estimated vs. actual forfeitures of stock options affect compensation expense, and what is a true-up adjustment?
Companies estimate expected forfeitures to determine compensation expense, then adjust (true-up) as actual forfeitures occur. IFRS requires estimation while US GAAP allows a choice between estimation and recognizing forfeitures as they occur. At vesting, total expense reflects actual vesting.
How is a modification to a share-based payment arrangement accounted for when a company reprices stock options?
When stock options are repriced, the total compensation equals the original grant-date fair value plus the incremental fair value (modified FV minus original FV, both measured at the modification date). The incremental cost is recognized over the remaining vesting period.
How do residual value guarantees affect lease accounting for the lessee under IFRS 16 / ASC 842?
Lessees include in their lease liability only the amount they expect to pay under a residual value guarantee, not the maximum guarantee amount. This is the difference between the guaranteed residual and the expected fair value at lease end.
How do credit transition probability matrices work, and how are they used in bond portfolio management?
Credit transition matrices show the probability of a bond migrating from one rating to another over a given period. Key applications include expected loss calculation, fallen angel risk assessment, and multi-year default probability estimation.
How do I derive a justified EV/EBITDA multiple from fundamentals, rather than just using comps?
A justified EV/EBITDA multiple is derived by dividing the FCFF-to-EBITDA conversion ratio by the spread between WACC and sustainable growth. This fundamental approach links relative valuation to intrinsic value drivers like growth, cost of capital, and reinvestment needs.
What is a leveraged recapitalization, and when does it create shareholder value?
A leveraged recapitalization involves taking on new debt to fund a large payout to shareholders. It creates value through tax shields on debt, reduced agency costs from forced cash discipline, and positive signaling, but increases financial distress risk.
What is the dual recourse feature of covered bonds and why does it make them safer than ABS?
Covered bonds have dual recourse: investors can claim against both the issuing bank and a segregated cover pool of assets. Unlike ABS where assets are sold to an SPV, covered bond assets remain on the issuer's balance sheet and are dynamically managed.
What are the different types of credit enhancement in asset-backed securities?
ABS credit enhancements are internal (subordination, overcollateralization, excess spread, reserve accounts) or external (surety bonds, letters of credit, cash collateral accounts). Subordination is the most common, creating a loss waterfall that protects senior tranches.
What is a 'football field' valuation chart and how do analysts construct one?
A football field chart displays the valuation range from each methodology as a horizontal bar on a common axis. Where bars overlap is the most defensible valuation range, often used as a negotiation anchor in M&A.
Can someone walk through the enterprise value to equity value bridge with all the adjustments?
The enterprise value to equity value bridge subtracts all non-equity claims (debt, preferred stock, minority interest, pension deficit, leases) and adds back non-operating assets (cash, equity investments) to arrive at the value attributable to common shareholders.
How do you eliminate intercompany bond holdings in consolidation?
When a parent buys a subsidiary's bonds on the open market, the consolidated statements treat it as a constructive retirement. The difference between the subsidiary's bond payable carrying amount and the parent's investment cost creates a constructive gain or loss recognized in consolidated income. This difference amortizes away over the remaining bond life.
When should I use the residual income model instead of the DDM for equity valuation?
Prefer the Residual Income Model over the DDM when the company does not pay dividends, has negative free cash flows, or when you want to anchor valuation to current book value to reduce terminal value dependence. Prefer the DDM for stable dividend payers with reliable payout histories.
What intangible assets must be separately recognized at fair value in a business combination?
Intangible assets must be separately recognized from goodwill in a business combination if they meet the contractual-legal criterion or the separability criterion. Common examples include patents, customer relationships, trade names, and licensing agreements.
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