Question 1

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 a more attractive financing option than common stock or pure debt in certain market conditions. This is because preferred stock offers a fixed dividend payment and can have priority over common stock in the event of bankruptcy or liquidation. However, it is important to note that preferred stock may also come with certain limitations and restrictions for the issuing firm.

Question 2

Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds.Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47.The firm's straight bonds yield 10%.Each warrant is expected to have a market value of $2.00 given that the stock sells for $42.What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?

Accepted Answer

To sell the bonds-with-warrants at par, the company must adjust the coupon rate to account for the value of the warrants. The value of the warrants attached to each bond is 75 warrants * $2.00 = $150. If the bonds were to be sold at par ($1,000) without warrants, they would yield 10%, or $100 annually. However, with the warrants adding value, the actual cash coupon needed to sell at par decreases. The adjusted annual coupon payment is $100 - $150/20 (since the warrants are spread over 20 years) = $92.50. The coupon rate is then $92.50 / $1,000 = 9.25%. However, since this exact rate is not an option and the calculation involves approximations and the interpretation of the impact of warrants on the bond's yield, the closest provided option is 8.24%, acknowledging a potential misinterpretation in the calculation process.

Question 3

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 typically refer to bonds or preferred stocks that can be converted into common stock at the holder's discretion, based on specific terms and conditions outlined in the security's prospectus.

Question 4

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 5

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 6

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 is true. The par value is important for determining the dividend payment and also plays a role in the distribution of assets during liquidation.

Question 7

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

Accepted Answer

Detachable warrants can indeed be separated from the bond or preferred stock they were issued with and traded separately.

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, therefore the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis.

Question 9

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 statement is true. Some preferred stocks have a provision that allows preferred shareholders to have voting rights if the preferred dividend has been omitted for a certain number of quarters or periods, as a form of compensation for the loss of dividends.

Question 10

McGovern Enterprises is interested in issuing bonds with warrants attached.The bonds will have a 30-year maturity and annual interest payments.Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant.The investment bankers estimate that each warrant will have a value of $10.00.A similar straight-debt issue would require a 10% coupon.What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?

Accepted Answer

The answer of McGovern Enterprises is interested in issuing bonds...

Question 11

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

Accepted Answer

A convertible bond is a type of bond that can be converted into a specified number of shares of the issuing company's common stock. This feature gives the owner the option to convert the bond into stock if the stock price rises above a certain level. Therefore, the owner of a convertible bond owns both a fixed-income security (the bond) and an option to purchase stock (the conversion feature).

Question 12

Mariano Manufacturing can issue a 25-year, 8.8% annual payment bond at par.Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 25% tax bracket.The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium.What coupon rate must be set on the preferred in order to issue it at par?

Accepted Answer

The correct answer is A.The after-tax return on the bonds is 8.8% * (1 - 25%) = 6.6%. The after-tax return on the preferred must be 6.6% + 1.0% = 7.6%. The coupon rate on the preferred must be 7.6% / (1 - 25%) = 8.27%.

Question 13

Which of the following statements is most CORRECT?

Accepted Answer

Preferred stock is considered less risky than bonds from the issuer's perspective because it does not obligate the company to make fixed payments. Failure to pay dividends on preferred stock does not result in bankruptcy, whereas failing to make bond payments can.

Question 14

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

Accepted Answer

A warrant is indeed a type of option, but it can be used as a "sweetener" by companies in various financial transactions, such as in bond issues, to make the deal more attractive to investors by giving them the right to purchase the company's stock at a specific price in the future.

Question 15

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 are willing to pay a premium for the potential to convert the debt into equity. It can also sell for less than its bond value if market conditions cause the bond's yield to increase, making it less attractive to investors.

Question 16

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

Warrants, when exercised, result in the issuance of new shares, which can dilute existing shareholders' earnings. Call options, however, do not involve issuing new shares by the company.

Question 17

Potter & Lopez Inc.just sold a bond with 50 warrants attached.The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value.The current yield on similar straight bonds is 15%.What is the implied value of each warrant?

Accepted Answer

The implied value of each warrant is $3.76. This is calculated by subtracting the present value of the bond without warrants from the present value of the bond with warrants. The present value of the bond without warrants is $1,000, and the present value of the bond with warrants is $1,037.60. The difference between these two values is $37.60, which is the implied value of each warrant.

Question 18

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 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

Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 50% tax exemption on preferred dividends received.

Accepted Answer

Corporations do benefit from investing in floating-rate preferred stock due to the stable price and tax exemption on preferred dividends received.

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