Deck 19: Convertibles, Warrants, and Derivatives

Question 1

A pure bond value is the value of a non-convertible bond with the same amount of risk as the convertible bond being measured.

Answer 1

True

Question 2

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

Answer 2

False

Question 3

The downside risk is defined as the difference between the market price and the floor value of a bond.

Answer 3

True

Question 4

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

Question 5

To calculate the downside risk of a bond in percent, divide the dollar amount by which the market price could fall (before it reaches the floor value) by the market price.

Question 6

A conversion premium is ultimately the additional amount given up to convert the bond to stock.

Question 7

If market rates of interest change, the "floor value" of a convertible bond can change.

Question 8

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

Question 9

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

Question 10

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

Question 11

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

Question 12

A convertible bond carries an element of downside risk if its "floor value" were to exceed the price of the company's stock.

Question 13

If a $1,000 par value convertible bond has a conversion ratio of 1 bond to 70 shares, the bond conversion price is $14.29.

Question 14

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 15

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

Question 16

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

Question 17

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

Question 18

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

Question 19

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

Question 20

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

Question 21

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

Question 22

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

Question 23

"Diluted earnings per share" must assume the conversion of all convertible securities, even if they haven't been converted.

Question 24

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

Question 25

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

Question 26

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

Question 27

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

Question 28

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

Question 29

A forced conversion will typically alter the corporate balance sheet favorably.

Question 30

The primary issuers of convertible bonds are smaller companies with low credit scores and high risk, but are growing.

Question 31

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

Question 32

Warrants are similar to convertible debt in that they require the issuance of debt in order to obtain the right to acquire common stock.

Question 33

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.

Question 34

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

Question 35

Warrants are similar to convertible debt in that they give the warrant holder the right to acquire common stock.

Question 36

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

Question 37

A warrant may carry a speculative premium above intrinsic value if the warrant isn't going to expire for a while.

Question 38

Warrants never sell for more than their intrinsic value.

Question 39

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

Question 40

Basic earnings per share includes all convertible bonds outstanding.

Question 41

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

Question 42

Warrants are considered in-the-money when the exercise price is above the current market price.

Question 43

A "put option" is the right to purchase securities at a predetermined price.

Question 44

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

Question 45

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

Question 46

"Futures contracts" can lock in prices, interest rates, and foreign currency exchange rates, compelling both parties to complete a transaction in accordance with these terms at a later date.

Question 47

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

Question 48

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

Question 49

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

Question 50

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

Question 51

A warrant is of huge benefit to the warrant holder when the stock rises far above the exercise price.

Question 52

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

Question 53

Warrants are considered in the computation of "diluted earnings per share," but not in "basic earnings per share."

Question 54

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

Question 55

In one stroke through forced conversion, the balance sheet changes, the debt becomes equity, and the debt disappears. The result is that the debt-to-equity ratio and the debt-to-asset ratio decline.

Question 56

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

Question 57

A "call option" is the right to purchase securities at a predetermined price.

Question 58

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

Question 59

A warrant is of huge benefit to the company when the stock rises far above the exercise price.

Question 60

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

Question 61

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

A) $325.
B) $800.
C) 66.74 shares.
D) 23.8 shares.

Question 62

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 that the convertible debt may be converted into.
D) ratio of the conversion premium to market value of a convertible security.

Question 63

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 64

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 or common 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 65

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 66

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 options are true.

Question 67

What is the difference between the conversion value and conversion premium?

A) The conversion value is the total value received if converted and the conversion premium is the difference between the value that would be received and how much the bond is selling for.
B) The conversion value is the total value of what the bond is selling for and the conversion premium is the difference between the value that would be received and how much the bond is selling for.
C) The conversion value is the total value received if converted and the conversion premium is the difference between the value that would be received and the par value of the stock.
D) There is no difference since conversion value and conversion premium mean the same thing.

Question 68

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 69

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 70

A convertible bond is often utilized

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

Question 71

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

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

Question 72

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

Question 73

The price of a convertible bond

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

Question 74

The theoretical floor value for a convertible bond is its

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

Question 75

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) adding the present value of the bond's interest payments to the present value of the bond's face value.

Question 76

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 77

The difference between convertible debt and non-convertible debt is

A) convertible debt is not affected by interest rate changes, while non-convertible debt is.
B) convertible debt is not considered a liability since it can be exchanged for stock, while non-convertible debt is.
C) convertible debt can be converted into stock at any point in time, while non-convertible debt can not.
D) convertible debt can come with downside protection, while non-convertible debt does not.

Question 78

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 79

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 80

A disadvantage to the investor of a convertible bond is that

A) the stock price may never rise above the 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 options are disadvantages.