Deck 19: Convertibles, Warrants, and Derivatives

Question 1

Conversion premiums are found by subtracting the current stock price from the bond's semiannual interest payment.

Answer 1

False

Question 2

A convertible bond has both a downside limit (the pure bond value) and an upside limit (the conversion price).

Answer 2

False

Question 3

If you purchased a convertible bond when first issued, you would pay more for the shares of stock you are entitled to than if you purchased the shares directly on the market at that point in time.

Answer 3

True

Question 4

The downside protection of a convertible bond's floor value insulates the investor from any possible loss.

Question 5

The conversion premium is equal to the market price minus the conversion value.

Question 6

Conversion premiums are influenced heavily by expectations of future stock performance.

Question 7

In general the average size of convertible issues is small compared to normal bond issues.

Question 8

The conversion price divided into the market value of a convertible bond provides the conversion ratio.

Question 9

Generally, once a convertible bond trades at a certain premium to its intrinsic value, or at a certain multiple of its conversion price, the bond must be converted into common stock.

Question 10

The conversion premium represents the dollar difference between the conversion value and the pure bond value.

Question 11

A $1,000 par value convertible bond has a conversion ratio of 50. The bond conversion price is $20.

Question 12

For the most downside protection, an investor should search for convertibles trading below par value near their floor value.

Question 13

A convertible bond has two separate sources of value, the bond investment value and the bond conversion value.

Question 14

The interest rate on convertible bonds is typically one-third higher than similar non-convertible issues.

Question 15

A convertible security is one that can be converted into common stock only at the option of the issuer.

Question 16

The primary issuers of convertible bonds are smaller, less than top-grade companies.

Question 17

Generally speaking, convertible bonds reverse the risk-return tradeoff that applies to most investments.

Question 18

Convertible securities are attractive because of their downside protection characteristics as well as upside potential.

Question 19

The face value of a convertible bond divided by the conversion price equals the number of shares a bondholder will receive upon conversion.

Question 20

The floor value of a bond can change if market interest rates for competitive bonds change.

Question 21

A warrant loses some of its financial leverage when the stock rises far above the exercise price.

Question 22

A forced conversion will alter the corporate balance sheet.

Question 23

On average, convertible bonds have conversion premiums of less than 10% at time of issue.

Question 24

Basic earnings per share includes all convertible bonds outstanding.

Question 25

Theoretically, stock options are granted to employees so that the employees will make decisions that benefit shareholders.

Question 26

A warrant's speculative premium equals the market price of the underlying common stock minus the option price.

Question 27

The premium for a warrant would increase if its underlying common stock has a negative market outlook.

Question 28

Because a warrant is dependent on the market movement of an underlying stock, it is highly speculative in nature.

Question 29

Forced conversion refers to the corporation calling a convertible bond when the market price of the stock is above the conversion price by more than a small percentage.

Question 30

A call provision is a commonly used device by a corporation to force conversion into common stock.

Question 31

Diluted earnings per share must include all convertible securities.

Question 32

A warrant may carry a speculative premium above intrinsic value if it will not expire until far into the future.

Question 33

Basic earnings per share does not include the dilutive effects of all of a firm's convertible bonds.

Question 34

Warrants are considered only in the computation of diluted earnings per share.

Question 35

Warrants never sell for more than their intrinsic value.

Question 36

As a financing device for creating common stock, warrants are usually more desirable than convertible bonds.

Question 37

Most corporations include call provisions in agreements relating to the issue of warrants.

Question 38

On average, convertible bonds have call premiums of less than 10% at time of issue.

Question 39

Warrants are often attached to debt securities to increase the debt issue's attractiveness to investors.

Question 40

In order to calculate basic earnings per share, the earnings after taxes have to be adjusted for the elimination of the convertible bond interest expense.

Question 41

The floor price of a convertible bond cannot fall below

A) the conversion ratio.
B) the conversion price.
C) the conversion premium.
D) the pure bond value.

Question 42

Convertible bonds and convertible preferred stock are used on a regular basis by corporations to diversify their capital structure.

Question 43

The conversion ratio is the

A) price at which a convertible security is exchanged into common stock.
B) ratio of conversion value to market value of a convertible security.
C) number of shares of common stock into which the convertible may be converted.
D) ratio of the conversion premium to market value of a convertible security.

Question 44

A $1,000 par value bond with a conversion price of $50 has a conversion ratio of

A) $40
B) 40 shares
C) $20
D) 20 shares

Question 45

The theoretical floor value for a convertible bond is its

A) conversion price.
B) conversion value.
C) par value.
D) pure bond value.

Question 46

When the market price of a common stock rises above the conversion price, the convertible should always be converted immediately before it drops.

Question 47

Expectations of a significant increase in the price of a firm's common stock will result in

A) large conversion premiums for the firm's convertible bonds.
B) small conversion premiums for the firm's convertible bonds.
C) negative conversion premiums for the firm's convertible bonds.
D) no effect at all on conversion premiums.

Question 48

The conversion value is equal to the conversion ratio times the conversion price.

Question 49

If the price of common stock associated with a convertible bond is less than the conversion price

A) the bond will sell at its pure bond value.
B) the bond will sell at its par value.
C) the bond will sell at its conversion value.
D) there is not enough information to tell what the bond price will be.

Question 50

The conversion premium of a convertible is generally greater when the market price of the stock is below the conversion price.

Question 51

The price of a convertible bond

A) has downside as well upside limitations.
B) has only upside limitations.
C) has only downside limitations.
D) has no upside or downside limitations.

Question 52

The conversion premium will be large

A) if investors have great expectations for the price of the common stock.
B) if interest rates decline.
C) when the conversion value is much greater than the pure bond value.
D) when the stock price is very stable.

Question 53

A convertible bond is currently selling for $970. It is convertible into 15 shares of common which presently sell for $50 per share. The conversion premium is

A) $90
B) $220
C) 57 shares
D) 13 shares

Question 54

A convertible security is almost always

A) a security that can be converted into any other type of security.
B) a debt security that can only be converted into preferred stock.
C) a security that can be converted into common stock at the holder's option.
D) a security that can be converted into common stock only at the option of the issuing corporation.

Question 55

A convertible bond is currently selling for $1,125. It is convertible into 20 shares of common which presently sell for $40 per share. The conversion premium is

A) $325
B) $215
C) 66.74 shares
D) 23.8 shares

Question 56

Convertible bonds offer minimal risk of loss to the investor due to their floor value.

Question 57

The conversion premium is the greatest and the downside risk the smallest when

A) the conversion value equals the pure bond value.
B) the conversion value is greater than the pure bond value.
C) the conversion value is less than the pure bond value.
D) the stock price is expected to go up drastically.

Question 58

Forced conversions of convertible bonds occur when unethical corporate executives call corporate bonds prematurely.

Question 59

Which of the following is true?

A) As the price of common stock increases, the market price of a convertible bond and the conversion premium increase.
B) As the price of common stock increases, the market price of a convertible bond and the conversion value increase.
C) As the price of common stock increases, the conversion value and the floor price increase.
D) Two of the above are true.

Question 60

Investors will generally choose the call price rather than the shares of stock during a forced conversion.

Question 61

A convertible bond is often utilized

A) as a sweetener when selling debt.
B) to sell common at prices higher than those prevailing when funds are needed.
C) when there is no demand for straight debt.
D) All of these.

Question 62

Warrants are

A) long-term options to sell shares of the issuing firm's stock.
B) fairly stable, low-risk investments.
C) investments whose value is directly related to the price of the underlying stock.
D) structured to sell for precisely their intrinsic value.

Question 63

The "floor" or pure bond value of a convertible bond is found by

A) multiplying the price of the firm's common stock by the conversion ratio.
B) multiplying the bond's conversion premium by the price of the firm's common stock.
C) multiplying the price of the firm's common stock by the conversion ratio and adding the present value of the bond's face value.
D) finding the present value of the bond's interest payments and adding the present value of the bond's face value.

Question 64

Which of the following is not a characteristic of convertible bond issues?

A) The average size of the offering is small.
B) A 15-20% conversion premium at time of issue is common.
C) Large companies with billions of dollars in sales and assets are the primary issuers.
D) Primary issuers tend to have less than AAA credit ratings.

Question 65

Which of the following is true about warrants?

A) At high stock prices, the warrant premium is high.
B) A rising stock price is usually followed by an increase in the price of the warrant.
C) a and b are true.
D) None of these are true.

Question 66

Vickrey Technology has had net income of $1,500,000 in the current fiscal year. There are 1,000,000 shares of common stock outstanding along with convertible bonds, which have a total face value of $8 million. The $8 million is represented by 5,000 different $1,000 bonds. Each $1,000 bond pays 4 percent interest. The conversion ratio is 30. The firm is in a 30 percent tax bracket. What is Vickrey's diluted earnings per share?

A) $1.43
B) $1.81
C) $2.00
D) None of these

Question 67

When a company has a convertible bond in its capital structure,

A) it can reduce its debt-to-equity ratio by calling the bond.
B) there is no effect on the firm's earnings per share.
C) there is no advantage to the firm in forcing conversion of the bonds.
D) all of these.

Question 68

The interest rate on convertibles is generally ____________ the interest rate on similar nonconvertible instruments.

A) greater than
B) less than
C) the same as
D) at least twice

Question 69

Jacobs and Company has warrants outstanding, which are selling at a $2.50 premium above intrinsic value. Each warrant allows its owner to purchase one share of common stock at $26. If the common stock currently sells for $30, what is the warrant price?

A) $6.40
B) $6.75
C) $7.25
D) $6.50

Question 70

The intrinsic value of a warrant to buy 4 shares of Merton stock at $53 per share is $20. What is the current market price of Merton stock?

A) $55.00
B) $59.00
C) $58.00
D) None of these

Question 71

Which of the following characteristics are drawbacks of convertible bonds?

A) Downside protection is ineffectual if the bond is bought at a large premium over floor value.
B) Interest rates on the debt-instrument part of a convertible bond are frequently below market interest rates.
C) Conversion may be forced on the bondholder by call provisions on the convertible bond.
D) All of these are drawbacks of convertibles.

Question 72

A disadvantage to the investor of a convertible bond is that

A) the stock price may never rise above conversion price.
B) if interest rates rise, the pure bond value (floor price) will decline.
C) the interest rate on convertibles is generally one-third below the coupon rate on straight bonds of similar risk.
D) all of these are disadvantages.

Question 73

A step-up in the conversion price refers to

A) the ability of the company to step up the maturity of the bond to an earlier date.
B) the provision that decreases the conversion ratio the longer a convertible bond is held.
C) a refunding of a convertible bond when the conversion value equals the pure bond value.
D) none of these.

Question 74

The Burma Hat Company's warrant is trading for $10.20. The warrant carries the option to purchase two shares of common stock for $48. What is the speculative premium if the stock price is $51.30?

A) $3.30
B) $3.60
C) $6.60
D) None of these.

Question 75

The computation of basic earnings per share will include consideration of

A) all convertible securities.
B) only shares outstanding.
C) shares outstanding and convertible securities.
D) none of these.

Question 76

Mirrlees Corp. has 10,000 7% bonds convertible into 30 shares per $1000 bond. Mirrlees has 1,000,000 outstanding shares. Mirrlees has a tax rate of 40%. The average Aa bond yield at time of issue was 10%. Compute basic earnings per share if after-tax earnings are $1,400,000.

A) $0.71
B) $1.25
C) $1.33
D) $1.40

Question 77

The principle device used by the corporation to force conversion

A) is setting the conversion price above the current market price.
B) is reducing the amount of interest payments.
C) is buying bonds back at below par value.
D) is a call provision.

Question 78

One advantage to the corporation in selling a convertible bond is:

A) the interest rate on a convertible is lower than a straight debt issue of equal risk.
B) the bond may never get converted into common stock and create dilution.
C) if interest rates fall the bond is likely to be refunded.
D) all of these.

Question 79

If the stock price rises substantially above the conversion price, an advantage to the corporation would be

A) the premium would decrease.
B) the floor price would offer the investor downside protection.
C) the bond would most likely be converted into common stock and the debt would not have to be repaid.
D) none of these are advantages to the corporation.

Question 80

Conversion price is usually set _______ the prevailing market price of the common stock at the time the bond issue is sold.

A) at
B) below
C) above
D) one half