href="https://cashnews.co/finance" style="font-weight: bold; color: #1a73e8; text-decoration: none;">Finance is all about understanding the financial decisions that companies make from Investments to financing to Dividend policy but these questions can be trigged not just because of the math but also due to the underlying Concepts let’s get started first up let’s talk about residual Income models you may already know the basics of valuing a company but residual Income models can often trip people up the concept is simple it calculates value based on the Income that remains after Accounting for the cost of Equity but the tricky part recognizing when this model is most appropriate typically residual Income is a good choice when the company doesn’t pay Dividends or when future Cash Flows are unpredictable you’ll need to watch out for questions that try to mislead you by presenting a Profitable company with inconsistent Dividends and asking you to pick the best Valuation model remember residual Income is suitable when Dividends and and Cash Flows are difficult to project but future Income is fairly stable next let’s discuss M and A Mergers and Acquisitions and synergies one popular question format is about synergies the additional value created when two companies merge they might ask you to calculate the net acquisition value taking into account these synergies for example if company a acquires Company B and expects to create $50 million in synergies but pays a premium of $40 million the net acquisition value is only $10 million easy right but watch out they might throw in other numbers like the acquirer cost of Capital that are irrelevant to this calculation focus on Synergy value minus the premium paid it’s a simple calculation but can trip you up if you’re distracted by irrelevant details now let’s cover the cost of Capital it’s fundamental yet a common point of confusion especially when dealing with multiple projects that differ in Risk say you’re given two projects one low risk one high risk should you apply the company’s overall weighted average cost of Capital whack to to both not necessarily in real life each project should ideally be assessed using a whack adjusted for its specific risk CFA questions sometimes disguise this by subtly hinting at risk differences and asking you to apply whack always remember if a Project’s risk profile differs significantly from the overall company risk an adjusted whack is more appropriate for the exam look for hints that suggest individual projects risks and don’t be afraid to adjust accordingly dividend policy questions often come up particularly focusing on the clientele effect the idea is that different types of investors prefer different dividend policies retirees might prefer a steady Income through Dividends while younger investors might prefer growth the tricky part is when they frame a question that combines dividend policy with stock price reactions for example if a company suddenly Cuts Dividends to reinvest in growth how will the stock price respond here’s the key if a company changes its dividend policy it risks losing some of its dividend seeking investors which may cause the stock price to dip in the short term look out for question questions that test whether you understand this relationship between dividend policy and investor preferences Leveraged Buyouts or lbos are popular in corporate Finance and tend to show up on CFA level 2 as multi-step questions an lbo is when a company is purchased primarily with borrowed funds with the expectation that the Cash Flows of the acquired company will cover the Debt payments what makes lbo questions tricky is the leverage and how it impacts Returns on Equity if you’re asked to calculate post lbo return on Equity you’ll need to pay close attention to how much Equity versus Debt is used in the buyout with high leverage even modest Profit increases can translate into high Returns on the Equity portion but remember leverage also increases risk RK watch for questions that subtly test whether you understand how the added risk might affect expected returns another common source of confusion is free Cash Flow to firm fcff versus free Cash Flow to Equity FCF fcff includes all Cash Flows before paying interest making it a preet measure FCF however represents the Cash Flows available to to shareholders after paying interest and Debt obligations if a question gives you free Cash Flow to firm but asks for free Cash Flow to Equity remember the formula FCF equals fcff minus interest payments adjusted for Tax Plus net borrowing the exam might give you excess data or ask you to convert between these two so keep this formula handy and watch for any clues about Debt structure finally Capital structure questions often test your understanding of the tradeoff theory and pecking order Theory the tradeoff theory suggests that companies balance the tax benefits of Debt against the potential bankruptcy costs pecking order theory on the other hand says companies prioritize financing first from retained earnings then Debt and finally Equity tricky questions might ask which Theory a company with stable Cash Flows and high tax rates would prefer here’s a tip for stable Cash Flows and high tax rates the tradeoff theory may be more appropriate as the tax shield from Debt is valuable and the bankruptcy risk is lower pay close attention to the wording of questions to decide which the Theory best applies Corporate Finance questions don’t have to be intimidating if you understand the logic behind them by focusing on the fundamental concepts Valuation models Capital structure and Cash Flows you’ll be able to tackle even the trickiest questions confidently if you enjoyed this breakdown hit subscribe for more CFA level 2 insights happy studying and good good luck on your exam
welcome back CFA candidates today we’re diving into some of the trickiest corporate Finance questions you might face on the CF at level two exam Corporate
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