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CFA Level II Updated
Why does WACC calculation become circular when using market value weights, and how do I solve it?
WACC becomes circular because market value equity weights depend on the DCF output, which depends on WACC. Solutions include iterating until convergence, using target capital structure weights (most common on the CFA exam), or enabling Excel circular references.
Why should the terminal growth rate in a DCF never exceed long-run GDP growth?
The terminal growth rate should never exceed long-run GDP growth because the Gordon growth model assumes perpetual growth. A company growing faster than the economy forever would eventually become larger than the entire economy, which is impossible.
How does preferred stock of a subsidiary affect consolidation and noncontrolling interest?
Subsidiary preferred stock held by outsiders is part of noncontrolling interest. When allocating subsidiary income, first deduct preferred dividends from net income, then split the remaining common income between parent and NCI based on common ownership percentages. Cumulative preferred dividends must be deducted even if not declared.
What are normalized earnings and when do I need them for equity valuation?
Normalized earnings estimate mid-cycle earning power for cyclical companies using either historical average EPS or average ROE applied to current book value. Method 1 is simpler but ignores growth; Method 2 captures the expanded asset base but requires reliable book values.
How is in-process R&D treated in a business combination under US GAAP and IFRS?
Under current US GAAP and IFRS, in-process R&D acquired in a business combination is capitalized at fair value as an indefinite-lived intangible asset. It is not amortized while in progress but tested annually for impairment.
How do you bootstrap spot rates from the par yield curve step by step?
Bootstrapping extracts spot rates from the par yield curve one maturity at a time. Start with the 1-year spot rate (equals par yield), then use it to solve for the 2-year spot rate, and so on. Each step sets the par bond price to 100 and solves for the unknown longest spot rate.
When is P/B valuation most appropriate and how do you interpret a P/B below 1.0?
Price-to-book valuation works best for financial institutions and asset-heavy industries where balance sheet values are meaningful. The justified P/B ratio equals (ROE - g)/(r - g), so a P/B below 1.0 can signal either genuine undervaluation or value destruction when ROE is below the cost of equity.
What makes infrastructure a distinct alternative asset class? How do risk/return profiles compare to other alternatives?
Infrastructure stands out for its essential-service nature, regulated/contracted revenues, inflation linkage, and very long asset lives. It offers a risk-return profile between bonds and equity with strong income characteristics.
How is NLP used in finance? Can text data really predict stock movements?
NLP transforms unstructured text into quantitative signals for investment analysis. Key applications include sentiment analysis of earnings calls, topic modeling of Fed minutes, and detecting material changes in corporate filings.
What are the main theories on dividend policy and which one is 'correct' for the CFA exam?
Three major theories disagree on whether dividends matter. MM says irrelevant in perfect markets, bird-in-hand says investors prefer certainty of dividends, and tax preference says investors prefer capital gains if taxed at lower rates.
How do the option Greeks (delta, gamma, vega, theta) work together in practice? I need a practical mental model.
The Greeks measure how an option's price responds to small changes in different variables. Think of them as sensitivity dials on a control panel — they don't operate in isolation but interact in critical ways for position management.
When do you use the temporal method vs the current rate method for foreign subsidiary translation?
The temporal method (remeasurement) is used when the subsidiary's functional currency equals the parent's, with gains/losses in the income statement. The current rate method (translation) is used when the functional currency is the local currency, with gains/losses in OCI as a CTA.
How does defined benefit pension funded status appear on the balance sheet?
The balance sheet reports the funded status of the pension plan: Fair Value of Plan Assets minus PBO. If the PBO exceeds plan assets, a net pension liability is recorded. Changes each period include service cost, interest cost, actual return on assets, contributions, and benefits paid.
What are the different types of share repurchase programs and their trade-offs?
Four main buyback methods: open-market (most common, flexible, slow), fixed-price tender (premium price, fast), Dutch auction tender (range-based price discovery), and accelerated share repurchase (immediate retirement via investment bank). Each balances speed, flexibility, cost, and signaling...
How does market timing theory explain equity issuance patterns?
Market timing theory: firms issue equity at high valuations, and past timing decisions leave a persistent imprint on current leverage. Baker-Wurgler found cumulative market-to-book weight explains leverage.
What is negative binomial regression and when do I prefer it over Poisson?
Negative binomial regression extends Poisson by adding a dispersion parameter allowing variance to exceed mean, handling overdispersion common in financial count data...
How does adding a risk-free asset change the efficient frontier?
Adding rf transforms the efficient frontier from a curved hyperbola into a straight line. Both E[R] and standard deviation scale linearly with risky-asset weight, producing a line tangent to the old frontier...
What is a vector autoregression (VAR) model?
VAR is a multivariate AR where each variable depends on lags of itself and all others. No theoretical identification required. Foundation of macro policy analysis.
What is an error correction model (ECM)?
ECM models short-run dynamics of cointegrated series with an error correction term pulling back to long-run equilibrium. Lambda must be negative and significant for true cointegration.
What does yield curve normalization look like and when does it occur?
Yield curve normalization typically unfolds through a bull steepener...
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