CFA Level 2 Equity Investments: notes and free practice
CFA Level 2 Equity Investments applies valuation models to case evidence. Match dividends, equity cash flow, firm cash flow or residual income to the correct discount rate and bridge the model’s output to the requested equity value.
The key ideas, at a glance
Bridge operations to equity
Read the visual, then follow the worked example below. Use the stated case assumptions.
Illustrative worked case
amount
- Operating value
- 800
- Debt
- -100
- Excess cash
- 20
- Equity value
- 720
FCFF1 = 48, WACC = 9% and growth = 3%. Operating value = 48 / 0.06. Subtract debt and add excess cash before using a share count.
| Concept | Rule or decision | Common mistake |
|---|---|---|
| Bridge operations to equity | FCFF = EBIT(1 - tax) + depreciation - capex - Δ operating WC | Operating enterprise value per share is not equity value per share. |
| Date the terminal value | At end of year N: terminal value = D(N+1) / (r - g) | A terminal value at year 2 still needs two years of discounting. |
| Charge equity for capital | RI1 = EPS1 - r × B0; value = B0 + PV of future residual income | The equity charge is not the residual income; it must be subtracted from earnings. |
| Normalize the comparison | Match claim, earnings period and ownership characteristics | Stacking overlapping control or liquidity adjustments can double-count the same economic effect. |
01Bridge operations to equity
FCFF = EBIT(1 - tax) + depreciation - capex - Δ operating WC
Watch for: Operating enterprise value per share is not equity value per share.
02Date the terminal value
At end of year N: terminal value = D(N+1) / (r - g)
Watch for: A terminal value at year 2 still needs two years of discounting.
03Charge equity for capital
RI1 = EPS1 - r × B0; value = B0 + PV of future residual income
Watch for: The equity charge is not the residual income; it must be subtracted from earnings.
04Normalize the comparison
Match claim, earnings period and ownership characteristics
Watch for: Stacking overlapping control or liquidity adjustments can double-count the same economic effect.
Selected 2026 study concepts. Match your preparation to your registered exam-year curriculum. These notes are not complete curriculum coverage.
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CFA Level II: 20 practice MCQs
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Put the method to work
One worked example, from facts to answer
Given
Next FCFF 48, WACC 9%, growth 3%, debt 100 and excess cash 20.
Method
Operating value = 48 / 0.06 = 800; equity = 800 - 100 + 20.
Answer and interpretation
Equity value is 720 before dividing by the share count.
Original independent teaching example. Assumptions are stated above; this is not an official exam question or scoring key.
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10 free Equity Investments questions
Five mini-cases, two questions each. Read the case facts, choose an answer and review the method. Short teaching cases, not complete exam item sets or a mock.
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- Question 1 of 10Level II topic sample · Case 1 of 5Equity InvestmentsMultiple choice
Case facts
Mira forecasts next-year EBIT $120m, tax rate 25%, depreciation $20m, capital spending $30m and increased operating working capital $10m. FCFF then grows at 3% perpetually; WACC is 10%. Debt value is $200m, excess cash $50m and shares 50m. No other claims exist.
Mira’s forecast next-year free cash flow to the firm is:
Answer and explanations
120 × 0.75 + 20 - 30 - 10 = $70m next-year FCFF.
Review the method- A - correct: 120 × 0.75 + 20 - 30 - 10 = $70m next-year FCFF.
- B: 90 is after-tax EBIT before the remaining cash-flow adjustments.
- C: 100 does not deduct the supplied capital spending correctly.
- Question 2 of 10Level II topic sample · Case 1 of 5Equity InvestmentsMultiple choice
Case facts
Mira forecasts next-year EBIT $120m, tax rate 25%, depreciation $20m, capital spending $30m and increased operating working capital $10m. FCFF then grows at 3% perpetually; WACC is 10%. Debt value is $200m, excess cash $50m and shares 50m. No other claims exist.
Using Mira’s perpetual-growth assumptions, estimated equity value per share is:
Answer and explanations
Operating value = 70 / 0.07 = 1,000; equity per share = (1,000 - 200 + 50) / 50 = $17.
Review the method- A: 20 is operating value of 1,000 divided by shares, before debt and excess cash.
- B: 16 subtracts debt but omits the $50m excess cash.
- C - correct: Operating value = 70 / 0.07 = 1,000; equity per share = (1,000 - 200 + 50) / 50 = $17.
- Question 3 of 10Level II topic sample · Case 2 of 5Equity InvestmentsMultiple choice
Case facts
Rowan forecasts dividends per share of $2.00 in year 1 and $2.40 in year 2. From year 3 onward dividends grow at 3% perpetually. Required equity return is 11% throughout. Dividends are paid at year-end; assume the model’s perpetual-growth conditions hold.
Rowan’s terminal share value at the end of year 2 is:
Answer and explanations
D3 = 2.40 × 1.03 = 2.472; terminal value at year 2 = 2.472 / 0.08 = $30.90.
Review the method- A: 30 uses D2 instead of the first post-horizon dividend.
- B - correct: D3 = 2.40 × 1.03 = 2.472; terminal value at year 2 = 2.472 / 0.08 = $30.90.
- C: 22.47 divides D3 by the required return without subtracting growth.
- Question 4 of 10Level II topic sample · Case 2 of 5Equity InvestmentsMultiple choice
Case facts
Rowan forecasts dividends per share of $2.00 in year 1 and $2.40 in year 2. From year 3 onward dividends grow at 3% perpetually. Required equity return is 11% throughout. Dividends are paid at year-end; assume the model’s perpetual-growth conditions hold.
Rowan’s estimated share value today is closest to:
Answer and explanations
2 / 1.11 + (2.40 + 30.90) / 1.11² = about $28.83 today.
Review the method- A - correct: 2 / 1.11 + (2.40 + 30.90) / 1.11² = about $28.83 today.
- B: 33.30 combines year-2 dividend and terminal value without discounting.
- C: 32.70 adds the discounted first dividend to an undiscounted terminal value and misses D2.
- Question 5 of 10Level II topic sample · Case 3 of 5Equity InvestmentsMultiple choice
Case facts
Sable has beginning book value per share of $40 and forecast year-1 EPS of $5.80. Required equity return is 10%. Residual income grows at 4% perpetually from year 1. Assume clean-surplus accounting and that this residual-income model applies.
Sable’s forecast year-1 residual income per share is:
Answer and explanations
Subtract the charge on beginning book equity: RI1 = 5.80 - 10% × 40 = $1.80 per share.
Review the method- A: 5.80 is earnings before charging equity capital.
- B: 4.00 is the equity capital charge, not residual income.
- C - correct: Subtract the charge on beginning book equity: RI1 = 5.80 - 10% × 40 = $1.80 per share.
- Question 6 of 10Level II topic sample · Case 3 of 5Equity InvestmentsMultiple choice
Case facts
Sable has beginning book value per share of $40 and forecast year-1 EPS of $5.80. Required equity return is 10%. Residual income grows at 4% perpetually from year 1. Assume clean-surplus accounting and that this residual-income model applies.
Sable’s value per share under the supplied residual-income growth model is:
Answer and explanations
40 + 1.80 / (0.10 - 0.04) = $70 per share under the stated model.
Review the method- A: 58 ignores residual-income growth when capitalizing RI1.
- B - correct: 40 + 1.80 / (0.10 - 0.04) = $70 per share under the stated model.
- C: 30 is the present value of future residual income before adding beginning book value.
- Question 7 of 10Level II topic sample · Case 4 of 5Equity InvestmentsMultiple choice
Case facts
Arlo has normalized forward EPS of $4 and is valued at an appropriate comparable forward P/E of 12 times. Separately, operating enterprise value is estimated at $700m, debt $150m and excess cash $30m, with 20m shares. There are no other claims; these are separate valuation approaches.
Arlo’s share value under the forward P/E comparison is:
Answer and explanations
Forward EPS $4 × comparable forward P/E 12 = $48 per share.
Review the method- A - correct: Forward EPS $4 × comparable forward P/E 12 = $48 per share.
- B: Dividing the multiple by EPS is not the valuation relation.
- C: 16 does not multiply the supplied EPS by the comparable multiple.
- Question 8 of 10Level II topic sample · Case 4 of 5Equity InvestmentsMultiple choice
Case facts
Arlo has normalized forward EPS of $4 and is valued at an appropriate comparable forward P/E of 12 times. Separately, operating enterprise value is estimated at $700m, debt $150m and excess cash $30m, with 20m shares. There are no other claims; these are separate valuation approaches.
Arlo’s separate enterprise-value approach implies equity value per share of:
Answer and explanations
(Operating value 700 - debt 150 + excess cash 30) / 20 = $29 per share.
Review the method- A: 35 is operating enterprise value per share before financing adjustments.
- B: 27.50 subtracts debt but fails to add excess cash.
- C - correct: (Operating value 700 - debt 150 + excess cash 30) / 20 = $29 per share.
- Question 9 of 10Level II topic sample · Case 5 of 5Equity InvestmentsMultiple choice
Case facts
A private company reports net income of $18m. An owner’s compensation exceeds a market replacement salary by $2m pretax; that excess will not continue. Tax rate is 25% and no other adjustment is needed. A control-value equity estimate of $100m separately requires a 15% discount for lack of marketability, with no other discounts.
The private company’s normalized net income is:
Answer and explanations
18 + 2 × (1 - 0.25) = $19.5m after adding back the after-tax excess compensation.
Review the method- A: 20 adds the pretax adjustment without accounting for tax.
- B - correct: 18 + 2 × (1 - 0.25) = $19.5m after adding back the after-tax excess compensation.
- C: 16.5 deducts the excess expense again rather than normalizing it out.
- Question 10 of 10Level II topic sample · Case 5 of 5Equity InvestmentsMultiple choice
Case facts
A private company reports net income of $18m. An owner’s compensation exceeds a market replacement salary by $2m pretax; that excess will not continue. Tax rate is 25% and no other adjustment is needed. A control-value equity estimate of $100m separately requires a 15% discount for lack of marketability, with no other discounts.
After the specified marketability adjustment, the separate equity estimate is:
Answer and explanations
Apply the stated discount to its base: 100 × (1 - 0.15) = $85m.
Review the method- A - correct: Apply the stated discount to its base: 100 × (1 - 0.15) = $85m.
- B: 115 adds a premium rather than applying a discount.
- C: Dividing by 1.15 is not applying a 15% discount to the stated value.
Four ideas to put to work
Find the method you need
Start with: Discounting, operating versus equity cash flow, book value and enterprise-value conventions.
METHOD 01
Bridge operations to equity
FCFF = EBIT(1 - tax) + depreciation - capex - Δ operating WC
- Discount FCFF at WACC and FCFE at the required equity return.
- Use next-period cash flow for a constant-growth perpetuity.
- Add excess cash and subtract debt and other non-equity claims before dividing by shares.
Worked example
- Given
- Next FCFF 48, WACC 9%, growth 3%, debt 100 and excess cash 20.
- Calculate / decide
- Operating value = 48 / 0.06 = 800; equity = 800 - 100 + 20.
- Result
- Equity value is 720 before dividing by the share count.
Watch for: Operating enterprise value per share is not equity value per share.
Practise this ideaMETHOD 02
Date the terminal value
At end of year N: terminal value = D(N+1) / (r - g)
- Forecast each dividend during the explicit horizon.
- Use the first post-horizon dividend in the terminal numerator.
- Discount both the terminal value and explicit dividends to today.
Worked example
- Given
- D1 = 1.50, D2 = 1.80, growth after year 2 = 4%, required return 10%.
- Calculate / decide
- D3 = 1.872; terminal value at year 2 = 1.872 / 0.06 = 31.20.
- Result
- Today’s value is 1.50 / 1.10 + (1.80 + 31.20) / 1.10² = about 28.64.
Watch for: A terminal value at year 2 still needs two years of discounting.
Practise this ideaMETHOD 03
Charge equity for capital
RI1 = EPS1 - r × B0; value = B0 + PV of future residual income
- Use beginning book value for the equity charge.
- Subtract the charge from earnings to calculate residual income.
- For constant RI growth below r, add RI1 / (r - growth) to beginning book value.
Worked example
- Given
- B0 = 30, EPS1 = 4.20, r = 10%, RI growth = 2%.
- Calculate / decide
- RI1 = 4.20 - 3 = 1.20; value = 30 + 1.20 / 0.08.
- Result
- Estimated value is 45 per share under the specified clean-surplus model.
Watch for: The equity charge is not the residual income; it must be subtracted from earnings.
Practise this ideaMETHOD 04
Normalize the comparison
Match claim, earnings period and ownership characteristics
- Use forward earnings with a forward P/E and check peer comparability.
- Adjust nonrecurring or nonmarket expenses on an after-tax basis.
- Apply only the discounts warranted by the stated ownership and liquidity assumptions.
Worked example
- Given
- Reported income 12; excess owner expense 1 pretax; tax 20%.
- Calculate / decide
- Normalized income = 12 + 1 × 0.80 = 12.80.
- Result
- Add back only the after-tax excess, not the owner’s full salary.
Watch for: Stacking overlapping control or liquidity adjustments can double-count the same economic effect.
Practise this ideaQuestions about this topic
- When does an FCFF valuation become an equity value?
- After discounting firm cash flow at an appropriate WACC, bridge the resulting operating value to equity by adding relevant nonoperating assets and subtracting debt and other non-equity claims under the case assumptions.
- Why does terminal value need a date?
- A constant-growth terminal value is located at the end of the explicit forecast horizon and uses the first cash flow after that date. Discount it back to the valuation date before adding it to other present values.
- How does residual income differ from earnings?
- Residual income deducts a required equity capital charge from earnings. Positive earnings can still produce negative residual income if they fail to compensate for the required return on the equity capital used.
Apply the topic to a focused case
CFA Level 2 equity valuation model selection
A dividend model is useful when dividends reflect the cash that can sustainably be distributed to equity holders. The absence of a current dividend does not mean equity has no value; it may instead make a cash-flow or other model more informative. Select a growth structure that fits the expected transition in profitability and payout. For a constant-growth perpetuity, the required return must exceed the assumed perpetual growth rate.
- Case facts
- Next-year FCFF is 30 million, WACC is 8%, perpetual growth is 2%, debt is 100 million and excess cash is 20 million. Assume no other claims.
- Apply the method
- Operating value = 30 / (0.08 - 0.02) = 500 million. Equity value = 500 - 100 + 20.
- Interpretation
- Equity value is 420 million under these assumptions. This uses WACC because FCFF is a firm cash flow; the claim adjustments produce the equity value.
Independent teaching cases under the stated assumptions, rather than official questions or scoring keys.
Sources and curriculum scope
Official outlines establish curriculum scope. The explanations and worked examples are independent teaching material; the sources do not verify or endorse them.
- 2026 CFA Level II outline: Equity Investments
- Official Level 2 format and curriculum
- 2026 CFA Level 2 curriculum outline
- 2027 CFA Level 2 curriculum outline
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