chapter 9
The Barge Towing Corporation has announced in a tombstone ad that it will issue $500,000,000 of 6 1/2% convertible subordinated debenture bonds convertible into common stock at $10.50. The bonds will mature in November 2040 and are being issued at a $1,000 par value. If the bonds were subsequently trading in the market at $1,020, the market price of the common stock, to be on parity with the bond, will be: a. $9.54 b. $10.20 c. $10.74 d. $12.04
The conversion price is given as $10.50. To find the conversion ratio, divide the par value ($1,000) of the bond by the conversion price of $10.50. This equals a conversion ratio of 95 to 1 ($1,000 divided by $10.50 equals 95). To find parity (equality in dollar value) for the stock, divide the market price of the bond by the conversion ratio. The market price of the bond is 102 ($1,020) and the conversion ratio is 95 to 1. Therefore, $1,020 divided by 95 equals approximately $10.74. This would be the parity price for the stock.
Which TWO of the following statements are TRUE regarding brokered CDs sold by registered representatives? I.These instruments are insured by the FDIC if the issuer declares bankruptcy II.These instruments are covered by SIPC if the issuer declares bankruptcy III.These instruments are insured by the FDIC if the broker-dealer declares bankruptcy IV.These instruments are covered by SIPC if the broker-dealer declares bankruptcy a. I and III b. I and IV c. II and III d. II and IV
b A DEF corporation convertible bond is convertible at $40. DEF common is selling at $50. At what price should the bond be selling for it to be at a 10% premium to the common? a. 80 b. 88 c. 125 d. 137 1/2
Relative to a convertible bond, which of the following choices will produce a desirable arbitrage situation? a. The stock is at parity with the bond b. The stock is at a premium to parity and the bond is trading at par c. The stock is at a discount to parity and the bond is trading at par d. The yield on the bond equals the yield on the stock
b An arbitrage situation occurs when there is a price difference in comparable securities. If the stock is selling above parity, the value of the stock received from converting the bond is more than the value of the bond. An investor could sell the stock short and buy the bond, and then convert the bond and use the stock to cover the short position. For example, a bond convertible into 25 shares is trading at 104 and the stock is selling at $42. If an investor sold 25 shares short at $42 (equaling $1,050), that would be worth more than the value of the bond ($1,040).
An investor purchasing a reverse convertible security would be MOST interested in: a. Preservation of capital b. High current income c. Capital appreciation d. Conservative income
b An investor purchasing a reverse convertible security is seeking an above-market coupon rate. Reverse convertible securities are short-term notes issued by banks and broker-dealers that usually pay a coupon rate above prevailing market rates. They are considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value known as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of her principal (the most beneficial option). The investor will not be able to participate if the underlying asset increased. If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal.
In what order of priority do the following investors rank if a company declares bankruptcy? I. Convertible preferred shareholders II. Debenture holders III. Common shareholders IV. Secured bondholders a.I, III, II, IV b.IV, II, I, III c.III, I, IV, II d.II, IV, III, I
b In the event a corporation declares bankruptcy and must liquidate its assets, bondholders (creditors) have the first claim, followed by shareholders (owners). •For a corporation's bondholders, the first payment is made to its secured bondholders (i.e., owners of bonds that are backed by specific tangible assets), then payments are directed to its debentures holders (i.e., owners of bonds that are backed by the full faith and credit of the issuing corporation). •For a corporation's stockholders, the preferred shareholders have a higher payment priority than the common shareholders. Ultimately, the order is (1) secured bondholders, (2) unsecured bondholders, (3) preferred shareholders, and (4) common shareholders.
Which of the following money-market instruments does NOT trade in the secondary market? a. Directly placed commercial paper b. Eurodollar CDs c. Repurchase agreements d. Bankers' acceptances (BAs)
c Repurchase agreements typically are not traded in the secondary market. Eurodollar CDs are certificates of deposit payable in Eurodollars (U.S. currency on deposit in foreign banks). Eurodollar CDs, commercial paper, and BAs are traded in the secondary market
A reverse convertible security would be MOST suitable for an investor who: a.Is anticipating a dramatic decrease in the value of the underlying asset b.Is willing to accept a lower yield in return for potential appreciation in the value of the underlying asset c.Desires higher yield and is anticipating the value of the underlying asset will remain stable d.Is anticipating an increase in the value of the issuer's common stock
c Reverse convertible securities are short-term notes issued by banks and broker-dealers that usually pay a coupon rate above prevailing market rates. They are considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value known as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of his principal. If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal. The investor is anticipating a stable price for the underlying asset and is not able to participate in any increase in the value of the underlying asset. If the investor was anticipating an increase in the value of the underlying asset, buying this asset would be more suitable. Choice (d) is incorrect since any change in the value of the issuer's common stock would have little impact on the value of a reverse convertible security.
A tombstone ad states that Southern California Gas is issuing 8 3/4% first mortgage bonds at a price of 96.35% of their par value. Which TWO of the following statements are TRUE? I.The bonds are being sold to yield 9.635% annually II.The bonds will pay interest of $87.50 annually III.The bonds are subject to the Trust Indenture Act of 1939 IV.An investor purchasing the bonds would not pay federal income tax on the interest received a. I and III b. I and IV c. II and III d. II and IV
c The rate of interest stated in the tombstone is 8 3/4%. This means the company will pay 8 3/4% of $1,000 or $87.50 per year in interest. The bonds are corporate bonds being issued by Southern California Gas Company (not the state of California) and are subject to the Trust Indenture Act of 1939. In addition, the interest received on a corporate bond is subject to federal and state income tax
A customer purchases a step-up, long-term certificate of deposit. The initial interest rate: a. Is higher than current market rates b. Is lower than current market rates c. Offers the client protection from interest-rate risk d. Offers the client protection against call risk
d A long-term (maturity exceeding one year), step-up CD offers an investor an interest rate that is initially lower than current market rates will pay for that maturity period. The rate will then be adjusted upward at predetermined intervals established by the offering bank. Since they are traded in the secondary market, changes in interest rates will cause the price of this security to fluctuate. Some long-term CDs will be callable by the issuing bank, and the investor may be required to reinvest the funds at prevailing lower interest rates.
A 7% convertible bond has a conversion ratio of 40. The bond has a nondilutive feature and the common is selling at $43 a share. If the company distributes a 10% stock dividend, which of the following statements is TRUE regarding the convertible bond? a. The conversion ratio remains at 40, but the conversion price is reduced b. The conversion ratio increases to 45.50 and the conversion price remains constant c. The conversion price decreases to $22.73 and the conversion ratio remains the same d. The conversion price decreases to $22.73 and the conversion ratio increases to 44
d A nondilutive feature requires that the conversion features be adjusted should there be a stock split or stock dividend. The conversion ratio will be increased and the conversion price will be reduced. The new conversion ratio will be 44 [the old ratio (40) plus the old ratio times the percentage dividend (40 x 10% = 4)]. The new conversion price will be the par value of the bond divided by the new conversion ratio ($1,000 divided by 44 equals $22.73).
To which of the following customers would a registered representative be LEAST likely to recommend an exchange-traded note (ETN)? a.A customer seeking to benefit if an index increases b.A customer seeking to benefit if an index decreases c.A customer seeking capital appreciation d.A customer seeking income on a regular basis
d Exchange-traded notes (ETNs) are a type of unsecured debt security. ETNs carry issuer risk that is tied to the creditworthiness of the financial institution backing the note. These securities are not like traditional fixed-income securities since they typically do not make interest payments to investors. An investor seeking income on a regular basis would not be a suitable candidate for an ETN. The returns are linked to the performance of an index, currency, or commodity and would be suitable for investors who want to speculate on the value of an index. Most ETNs are traded on a national exchange (e.g., NYSE) which has the feature of liquidity. Therefore, an investor seeking capital appreciation has the ablity to sell when advantageous
If a corporation is in liquidation, the holder of a subordinated debenture is paid: a. Before bank loans and before accounts payable b. Before bank loans and after accounts payable c. After bank loans and before accounts payable d. After bank loans and after accounts payable
d In a liquidation of a corporation, the subordinated debenture holders are paid after bank loans and after accounts payable or other creditors. The subordinated debenture holders are paid after everyone except preferred and common stockholders.
A corporation will be considered in default if it does not pay interest on all of the following bonds, EXCEPT a(n): a. Second mortgage bond b. Debenture c. Subordinated debenture d. Income bond
d Interest on an adjustment (income) bond needs to be paid only if the corporation has sufficient income. Interest on all other debt securities must be paid regardless of the corporation's income
Which of the following statements is TRUE concerning reverse convertible securities? a. An investor will receive a coupon rate below prevailing market rates b. An investor is anticipating a decrease in the value of the underlying asset c. They would be suitable for an investor who wants to own shares of the underlying asset d. The investor is anticipating that the price of the underlying asset would be above the knock-in value
d Reverse convertible securities are short-term notes issued by banks and broker-dealers that usually pay a coupon rate above prevailing market rates. They are considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value known as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of her principal (the most beneficial option). If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal. The investor is anticipating a stable price for the underlying asset and is not able to participate in any increase in the value of the underlying asset. Choice (c) is incorrect since the investor does not want to own the underlying asset.
A DEF corporation convertible bond is convertible at $40. DEF common is selling at $50. At what price should the bond be selling for it to be at a 10% premium to the common? a. 80 b. 88 c. 125 d. 137 1/2
d Since the bond is convertible at $40 a share, the bond can be converted into 25 shares of common stock ($1,000 par value divided by $40 per share). If the bond is converted, the total value of common stock will be $1,250 (25 shares x $50 market value). A 10% premium to the parity price is $1,375 ([10% x $1,250] + $1,250).
When raising capital, which TWO of the following securities are required to register with the SEC under the Securities Act of 1933? I.A REIT that will be listed on the NYSE II.Commercial paper issued by a finance company maturing in one month III.A Eurodollar bond issued by a U.S corporation IV.An American Depositary Receipt issued by a British company a. I and III b. I and IV c. II and III d. II and IV
b There is no specific exemption under the registration provisions of the Securities Act of 1933 for ADRs or REITs. They both issue shares of common stock and, if sold to the public in the U.S., require SEC registration. Corporate debt with a maturity of 270 days or less (i.e., commercial paper) is exempt from registration. Securities initially offered outside the U.S., for example Eurodollar bonds, are also exempt from SEC registration.
An investor buys a zero-coupon bond at 37. A few years later the bond's basis has been accreted for tax purposes to 42. If the bond is sold at 45, the investor will recognize: a. No gain or loss b. A 3-point capital gain c. A 8-point capital gain d. Ordinary income of 8 points
b When selling a zero-coupon security, if the bond is sold above the accreted value (not the original cost), it is considered a capital gain and, if sold below, a capital loss. According to IRS rules, the accretion added each year to the cost basis for a zero-coupon security is treated as interest income for that year. If a zero-coupon security is sold for its accreted value, the investor will have no gain or loss
