Question 1

A warrant is an option, and as such it cannot be used as a "sweetener."

Accepted Answer

A warrant can be used as a "sweetener" in financial transactions as an incentive for the investor to purchase a security.

Question 2

The owner of a convertible bond owns, in effect, both a bond and a call option.

Accepted Answer

This is because the investor can receive regular interest payments as they would with a bond, but also has the option to convert the bond into a specified number of shares of the issuing company's common stock at a set conversion price. This gives the investor the potential to benefit from future increases in the company's stock price.

Question 3

Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

Accepted Answer

This statement is true. Preferred stock usually has a par value and dividends are often expressed as a percentage of par. Additionally, in the event of liquidation, preferred stockholders are usually entitled to receive the par value before any payments are made to common stockholders.

Question 4

The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines.

Accepted Answer

The IRS allows the full amount of lease payments to be tax deductible if the lease meets certain criteria and qualifies as a true lease.

Question 5

Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm's income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm's balance sheet.

Accepted Answer

This is because the lessor (owner of the leased asset) retains ownership and the lessee (user of the leased asset) only has the right to use it. Therefore, the leased asset and associated liabilities do not need to appear on the lessee's balance sheet. However, this is only the case for operating leases and not capital leases, which are recorded as assets and liabilities on the lessee's balance sheet.

Question 6

A sale and leaseback arrangement is a type of financial, or capital, lease.

Accepted Answer

A sale and leaseback arrangement involves the sale of a tangible asset to a buyer who then leases the asset back to the original owner, creating a long-term rental agreement. This creates a capital lease, where the lessee (original owner) is essentially financing the purchase of the asset over the lease term through rental payments.

Question 7

Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder.

Accepted Answer

Convertible securities are indeed bonds or preferred stocks that can be converted into common stock at the option of the holder, according to the terms and conditions specified at the time of issuance.

Question 8

Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible.

Accepted Answer

Dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible, so the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis.

Question 9

Firms generally do not call their convertibles unless the conversion value is greater than the call price.

Accepted Answer

Firms typically call their convertible securities when the market price (conversion value) of the shares into which the bonds can be converted exceeds the call price, as this incentivizes bondholders to convert their bonds into equity, reducing the firm's debt obligations.

Question 10

Operating leases help to shift the risk of obsolescence from the user to the lessor.

Accepted Answer

Operating leases typically include provisions where the lessor is responsible for maintaining and updating the leased asset, which helps to shift the risk of obsolescence from the user to the lessor. This is one of the key advantages of operating leases for businesses who prefer to avoid the risk of investing in rapidly-changing technology or equipment.

Question 11

Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor.

Accepted Answer

In a sale and leaseback arrangement, the owner of the property (seller) sells it to a buyer and then leases it back from them, becoming the lessee. The buyer, therefore, becomes the lessor.

Question 12

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

Accepted Answer

The "preferred" in preferred stock refers to the preferential treatment in dividend payments and upon liquidation, not necessarily a higher expected return compared to common stock.

Question 13

Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost.

Accepted Answer

Preferred stock can be an attractive financing option for companies in certain market conditions, such as when interest rates are high or when common stock may not be desirable to potential investors.

Question 14

A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock.

Accepted Answer

Warrant holders do not have voting rights or receive dividends from the underlying stock, as they only have the right to purchase the stock at a specified price before the expiration date.

Question 15

Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters.

Accepted Answer

This is true. Some preferred stocks have a provision where preferred shareholders can vote if the company fails to pay dividends for a certain amount of time, typically two or more consecutive quarters. This is known as "cumulative voting rights."

Question 16

A detachable warrant is a warrant that can be removed from the security with which it was issued and traded separately from it. Most traded warrants are originally attached to bonds or preferred stocks.

Accepted Answer

This is a correct definition of a detachable warrant.

Question 17

The problem of dilution of stockholders' earnings never results from the sale of call options, but it can arise if warrants are used.

Accepted Answer

The answer of The problem of dilution of stockholders' earnings...

Question 18

A convertible debenture can never sell for more than its conversion value or less than its bond value.

Accepted Answer

A convertible debenture can sell for more than its conversion value if investors believe that the company's stock price will increase significantly, making the conversion option more valuable. It can also sell for less than its bond value if the company's financial health or creditworthiness is perceived as weak.

Question 19

Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

Accepted Answer

In the event of bankruptcy, preferred stockholders have priority over common stockholders with respect to liquidating proceeds, meaning they are paid out before common stockholders.

Question 20

Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget.

Accepted Answer

While leasing is a form of financing, it can also impact capital budgeting decisions. Leasing can represent a significant cash outflow that impacts the overall budget and investment decisions. Moreover, leasing may involve long-term agreements that can impact the timing and amount of future capital expenditures. Therefore, the availability of lease financing can indeed affect the size of the capital budget.

Quiz 20: Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles