Preferred Stock

ABC gold mining company has issued a preferred stock. Dividends on the issue may be paid as:

A Cash only Preferred dividends may only be paid in cash. This differs from common stock, which can be paid a dividend in the form of cash, stock, or product.

A corporation issues $100 par convertible preferred stock, convertible at $50 per share when the market price of the common is $30. The preferred is issued under an "anti-dilutive covenant." If the company declares a 25% stock dividend, which statements are TRUE? I The conversion price is adjusted to $40 II The conversion price is adjusted to $62.50 III The conversion ratio is adjusted to 2.5:1 IV The conversion ratio is adjusted to 1.6:1

A I and III Under an "anti-dilutive" covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $50 per share. If there is a 25% stock dividend, the new conversion price will be adjusted to $50/1.25 = $40 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/$40 = 2.5:1.

A corporation has issued $100 par, 6 1/2% cumulative convertible preferred stock, callable at par. The preferred is convertible into 2 shares of common stock. Currently, the preferred stock is trading at $98 while the common stock is trading at $52. If a customer buys 100 preferred shares, converts, and then sells the common stock in the market, the profit or loss is (ignoring commissions):

B $600 gain If the customer buys 100 shares of the preferred stock, he or she will pay 100 x $98 per share = $9,800. Since each share of preferred is convertible into 2 common shares, the 100 preferred shares will be converted into 2 x 100 = 200 common shares. The sale of 200 common shares at the current market price of $52 will yield $10,400. The net profit is: $10,400 - $9,800 = $600.

Which statement is FALSE about preferred stock?

B Dividends are paid quarterly Whereas common dividends are typically paid quarterly, preferred dividends are typically paid semi-annually - similar to bond interest payments (remember, both preferred and bonds are fixed income securities; common stock is not). Preferred stock dividends are paid before common dividends can be paid and preferred shareholders have a prior (senior) claim to assets in a liquidation before common shareholders.

Preferred stocks are most often suitable investments for the:

B corporate investor Corporations that receive dividends from investments held generally are allowed to exclude 50% of the dividends received from taxation. This exclusion does not apply to individual investors (however, individual investors get the benefit of taxation of cash dividends received at a substantially lower rate - 15% (or 20% for those in the highest tax bracket) - than do corporate investors). Thus, a corporation that receives dividends from common stock holdings, preferred stock holdings, or mutual fund holdings where the fund's income is from common and/or preferred stock investments, is allowed to exclude 50% of that income from taxation.

A corporation has issued $100 par, 8% convertible preferred stock, callable at par. The preferred is convertible into 1.4 shares of common stock. Currently, the preferred stock is trading at $105 while the common stock is trading at $72.75. The corporation calls the preferred stock at par. To realize the largest profit, a customer holding 100 shares of preferred stock should:

B sell the preferred shares at the current market price

What type of preferred stock can move in price as the price of the common stock moves?

C Convertible preferred

Which statement is TRUE when comparing convertible preferred stock and non-convertible preferred stock?

C Non-convertible preferred shares will have a higher yield than similar convertible shares of the same issuer Non-convertible preferred yields are higher than convertible yields. A non-convertible preferred stockholder gets a fixed rate of return without any growth potential. A convertible preferred stockholder can convert to common if the common's price rises, so growth potential is included. Because of this, yields for convertible preferred are lower than for non-convertible preferred.

During a period of stable interest rates, which type of preferred stock would show the greatest price volatility?

C Participating

A corporation issues $50 par convertible preferred stock, convertible at $20 per share, when the market price of the common is currently $10. Which statement is TRUE?

C The conversion ratio is 2.5:1 The conversion ratio is Par Value / Conversion Price. $50 Par / $20 Conversion Price = 2.5:1 Conversion Ratio.

If interest rates fall, issuers most likely will call:

C preferred issues trading at a premium If interest rates fall, issuers most likely will "call in" old high rate preferred and replace it by selling new preferred at the lower current rates. High rate preferred will sell at a premium if market interest rates are dropping. Preferred stocks do not have a stated maturity.

All of the following are terms associated with preferred stock EXCEPT:

C redeemable Preferred stock is not a redeemable security - it is a negotiable security. The stock cannot be redeemed with the issuer - an investor who wishes to liquidate must sell the stock in the market. Preferred stock can be callable, cumulative, and convertible.

XYZ Company has issued 10%, $100 par cumulative preferred stock. Two years ago, XYZ omitted its preferred dividend. Last year, it paid a preferred dividend of $5 per share. This year, XYZ wishes to pay a common dividend. In order to make the distribution to common shareholders, each preferred share must be paid a dividend of:

D $25 Since the preferred stock is cumulative, to make a dividend distribution to common shareholders, the company needs to pay all back, unpaid dividends plus this year's dividend (before a common dividend can be paid). The stated dividend rate on the preferred is 10% based on $100 par. Two years ago the entire dividend was omitted, so $10 per share must be paid. Last year, the corporation only paid $5, so there is another $5 that must be paid. Also, this year's dividend of $10 must be paid. The total dividend that must be paid is $25 per preferred share before a common dividend can be paid.

Preferred stock has all of the following features EXCEPT:

D Voting rights Preferred stock lacks voting rights - remember that it is a fixed income security that is very "bond-like." Preferred has a fixed rate of return (the dividend rate), has priority claim to assets upon dissolution over common, and has priority claim to dividends over common, if declared by the Board of Directors. Preferred stock does not have a fixed maturity date - it has an indefinite life.

Callable preferred stock is likely to be redeemed by the issuer if:

B interest rates fall If interest rates fall, issuers can "call in" old high rate preferred and replace it by selling new preferred at the lower current rates. Thus, calls take place when interest rates have fallen.

As interest rates fall, preferred stock prices will:

B rise Preferred stock is a fixed income security whose prices move inversely with interest rates. As interest rates fall, preferred stock prices rise, so that the preferred will give a yield that is competitive with the current market.

A corporation has issued $100 par, 8% cumulative convertible preferred stock, callable at par. The preferred is convertible into 1.4 shares of common stock. Currently, the preferred stock is trading at $102 while the common stock is trading at $75.50. The corporation calls the preferred stock at par plus accrued dividends of $2 per share. To realize the largest profit, a customer that purchased 100 shares of this preferred stock at par should:

C sell short - the common stock and convert the preferred for delivery to cover the short If the preferred shares are tendered at the call price, the owner receives $100 per share. Since par ($100) was paid for each share, there is no profit. If the preferred shares are sold at the current market price of $102, the owner has a profit of $2 per share. Since each preferred share is convertible into 1.4 common shares, the short sale (sale of borrowed shares) of 1.4 common shares will yield 1.4 x $75.50 = $105.70. The preferred can then be converted to common to cover the borrowed short position. This results in a $5.70 profit per share. Thus, selling short the common is the best choice. Continuing to hold the preferred does not make sense since dividend payments will cease. For this reason, buying additional preferred shares does not make sense either.

A customer buys 100 shares preferred at $110 per share. The par value is $100. The dividend rate is 5%. Each dividend payment will be:

A $250 The annual rate is 5% X $100 par value = $5 per share X 100 shares = $500. Since preferred dividends are paid semi-annually, each payment is $250.

ABC 8% $100 par preferred is trading at $120 in the market. The current yield is:

A 6.7% Current Yield = Annual Income / Market Price

ABC Company has outstanding 6% cumulative preferred stock. Two years ago, ABC paid a 6% preferred dividend. Last year, ABC paid a 4% preferred stock dividend. This year, ABC wishes to pay a common dividend. The preferred shareholders must receive:

D 8% On cumulative preferred stock, all back unpaid dividends PLUS this year's preferred dividend must be paid before a common dividend is paid. Thus, 2 years ago the full 6% preferred dividend was paid, so there is no arrearage; last year only 4% was paid, so 2% was missed. Before a common dividend can be paid this year, the missing 2% plus this year's 6% preferred dividend, or a total of 8% must be paid.