Question 1

Which of the following support the rationale for issuing convertible bonds?

Accepted Answer

All of the above are potential benefits of issuing convertible bonds. Convertible bonds often result in lower underwriting costs compared to issuing traditional equity, and they can also provide less expensive initial financing due to lower interest rates. Additionally, because convertible bonds can ultimately be converted into equity, they may result in less dilution for existing shareholders compared to issuing traditional equity.

Question 2

In which of the following ways do warrants differ from call options?
I.Warrants impact the firm while call options do not.
II.Call options generally have shorter maturities than warrants.
III.Any profit received from call options is taxable while that from warrants is not taxable.
IV.Volatility increases the value of call options but makes warrants less valuable.
V.The longer maturities of warrants make them less valuable.

Accepted Answer

I. Warrants do indeed impact the firm because when exercised, new shares are issued by the company, potentially diluting the stock. Call options, on the other hand, are agreements between traders and do not involve the company directly.II. Call options typically have shorter maturities than warrants. Warrants can last for several years, whereas call options usually have maturities up to a year or so.III, IV, and V are incorrect statements. The tax implications of profits from warrants and call options depend on the jurisdiction and specific tax laws, not a fundamental difference between the two. Both warrants and call options increase in value with volatility. The longer maturities of warrants are often seen as an advantage, giving more time for the investment to become profitable, not less valuable.

Question 3

Which of the following statements is correct?

Accepted Answer

Preferred dividends are not tax deductible for the issuing firm, unlike interest payments on debt. This is a key difference in the tax treatment of debt versus equity financing.

Question 4

Issuing bonds plus warrants is similar to issuing:

Accepted Answer

Issuing bonds plus warrants allows the bondholders to convert their bonds into equity shares using the warrants. Similarly, convertible bonds also allow the bondholders to convert their bonds into equity shares at a predetermined rate. Therefore, issuing bonds plus warrants is more similar to issuing convertible bonds.

Question 5

The ______ specifies the number of shares received for each convertible bond.

Accepted Answer

The conversion ratio specifies the number of shares received for each convertible bond. The conversion price is the price at which the bond can be converted to stock, while the subscription price and ratio are typically used in the context of new stock offerings.

Question 6

Hudson Bay Fishing Corporation has issued bonds that can be converted into common shares when the share price is $50.The current market price of the stock is $35.The bond has a face value of $1,000 and currently sells for $975.What is the conversion ratio for this bond?

Accepted Answer

The conversion ratio is calculated by dividing the bond's face value by the conversion price: $1,000 / $50 = 20.

Question 7

Which of the following are also referred to as a hybrid security?

Accepted Answer

All of the options listed are considered hybrid securities. Cumulative preferred shares have features of both debt and equity, convertible bonds have features of both debt and equity because they can be converted into common stock, and preferred shares have features of both debt and equity because they pay a fixed dividend like a bond but also have equity characteristics such as voting rights.

Question 8

Warrants are similar to call options on stocks.What is the warrant equivalent of the strike price?

Accepted Answer

The exercise price of a warrant is equivalent to the strike price of a call option. This is the price at which the holder of the warrant has the right to buy the underlying stock.

Question 9

Punta Oil Company has 600,000 shares outstanding and has just issued 640,000 warrants.Each warrant entitles its owner to buy one share anytime in the next quarter at a price of $40.The common stock price is current $50.What is the payoff to the warrant holders exercising them, rounded to the nearest dollar?

Accepted Answer

The payoff to the warrant holders can be calculated by finding the difference between the current stock price and the exercise price, then multiplying by the number of warrants. The current stock price is $50, and the exercise price is $40, so the difference is $10. With 640,000 warrants, the total payoff is $10 * 640,000 = $6,400,000. However, the correct answer is B) $3,096,774.19, which suggests there was a misunderstanding in the calculation. The correct calculation involves understanding the specific details of the question, but without additional context or a clear explanation for the numbers provided in the choices, the calculation based on the given information would lead to $6,400,000. The discrepancy suggests a need for clarification or a mistake in the question or answer choices.

Question 10

Which of the following statements regarding convertible bonds is true?

Accepted Answer

A) True - a convertible bond's floor value is the lowest price it can trade for as a bond before conversion.
B) True - the floor value is determined by taking the higher of the straight bond value or conversion value, providing a "floor" price for the security.
C) True - if the stock price rises above the conversion price, investors may choose to convert their bond into equity to take advantage of potential price appreciation.

Question 11

The price at which a convertible bond would sell for if it could NOT be converted into common shares is called:

Accepted Answer

The straight bond value represents the value of the convertible bond if it could not be converted into common shares. This is the price at which the bond would sell for in the absence of the conversion feature.

Question 12

Warrants attached to a bond:

Accepted Answer

Warrants attached to a bond typically decrease the risk of the bond, as they provide the bondholder with the option to purchase additional shares of the issuer's stock at a set price. This potential for additional gains can offset any potential losses from the bond. They are not used as sweeteners to make bond issues less attractive and do not typically increase the risk of the bond.

Question 13

Evaluate the following statement:
The cost of a preferred share is the rate of return shareholders require on the firm's preferred stock.

Accepted Answer

The answer of Evaluate the following statement:
The cost of a...

Question 14

Use the following statements to answer this question:
I.A warrant's value is due, in part, to its long-term maturity.
II.The intrinsic value of a warrant does not depend on the volatility of the stock.

Accepted Answer

Statement I is correct because a warrant's long-term maturity allows the holder more time to exercise the warrant and benefit from any increase in the stock's price. Statement II is incorrect because the intrinsic value of a warrant is affected by the volatility of the underlying stock. Higher volatility can lead to a higher value of the warrant due to the potential for larger price movements.

Question 15

What is the tax value of money?

Accepted Answer

The answer of What is the tax value of money?
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Question 16

A company has 20 million shares outstanding that are trading at $30 per share.The company has 2 million warrants outstanding that have an exercise price of $28 per share.Each warrant entitles the owner to purchase one share.What is the payoff to the warrant holders exercising them, rounded to the nearest dollar?

Accepted Answer

The payoff to the warrant holders is calculated by the difference between the current trading price and the exercise price, multiplied by the number of warrants. Here, it's ($30 - $28) * 2,000,000 = $4,000,000. However, the correct answer is not listed directly; the closest option is A) $3,636,364, which seems to be a calculation error. The explanation provided is for the correct calculation method, but the options given do not match the calculated result.

Question 17

Which of the following characteristics apply to floating rate preferred shares?
I.Long maturity date
II.Pay a fixed dividend
III.Dividends are paid at regular intervals
IV.The right to sell them back to the issuer

Accepted Answer

Floating rate preferred shares have a long maturity date (I) and pay dividends at regular intervals (III), but they do not pay a fixed dividend (II) or give the right to sell them back to the issuer (IV). Therefore, the correct characteristics for floating rate preferred shares are I and III, which are only found in option D.

Question 18

Which of the following is true regarding convertible bonds?

Accepted Answer

The value of convertible debt is influenced by the risk of default, similar to traditional bonds. This is because the bond component of a convertible bond is still a debt obligation of the company, and its value will be affected by the company's creditworthiness and the likelihood of default.

Question 19

In which of the following ways are some preferred shares similar to bonds?
I.Call provisions
II.Convertible features
III.Retraction provisions
IV.Rated by rating agencies

Accepted Answer

Preferred shares and bonds can share characteristics such as call provisions (allowing the issuer to redeem them before maturity), convertible features (can be converted into another form of security), retraction provisions (allowing the holder to sell them back to the issuer), and both can be rated by rating agencies to assess their credit risk.

Question 20

The conversion premium is defined as which of the following?

Accepted Answer

The conversion premium is the percentage difference between the market value at which the convertible security is trading and its conversion value. It represents the extra cost paid by investors for the privilege of holding a security with the option to convert it into common shares in the future. Therefore, the correct choice is D.

Quiz 19: Equity and Hybrid Instruments