Unit 5
A customer purchases an ABC 6½% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading 2 points below parity, the price of ABC common is
$14. The conversion ratio is computed by dividing par value by the conversion price ($100 par ÷ $20 = 5). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($80 ÷ 5 = $16). $16 − 2 = $14.
ABC Corporation has issued a convertible preferred stock with a par value of $100. The stock is convertible at $40. The current market price of the stock is $80. It would be correct to state that the conversion ratio is
2.5:1 When a $100 par preferred has a conversion price of $40, the stockholder can convert into 2.5 shares. That is a 2.5:1 ratio. The current market price of the stock is only relevant if the question asks about the parity price (which is $32).
ABC Company has issued $20,000,000 of convertible bonds with a coupon of 5% and a current market value of 120. The conversion price is $40. If all the bonds are converted, how many additional shares of common stock will ABC have outstanding?
500,000 Each bond will convert to 25 shares of common stock ($1,000 ÷ $40). 20,000 bonds were issued ($20,000,000 ÷ $1,000). Therefore, 500,000 additional shares (20,000 × 25) will be outstanding if all the bonds are converted.
An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $700. For tax purposes, this would result in
a capital loss of $20. The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $700 is $20 less than the basis, the investor has a long-term capital loss.
Corporate bonds that are guaranteed are
guaranteed as to payment of principal and interest by another corporation.
An investor whose primary objective is a steady income flow would probably be best served by building a portfolio of
investment-grade debentures.
The STU Corporation has issued common stock, preferred stock, promissory notes, and mortgage bonds. Should STU enter bankruptcy proceedings, the order of payment against claims would be
the mortgage bonds, the promissory notes, the preferred stock, and the common stock.
An investor purchases a bond on its initial public offering. Even though the bond has a maturity value of $1,000 in 10 years, the offering price is only $600. If the bond is held to maturity,
there are no tax consequences to report.
Which of the following is not a type of corporate debt instrument? A) Income bond B) Mortgage bond C) Revenue bond D) Subordinated debenture
Revenue bond
A bond was issued 3 years ago with a coupon of 6%. The bond matures in 21 years and is callable at 103. Current market interest rates are 8%. Which of the following is most likely true? A) The bond is selling at a discount. B) The bond will be called. C) The coupon will be changed. D) The bond is selling at a premium.
The bond is selling at a discount.
An investor owns a convertible debenture with a conversion price of $10. If a 10% stock dividend is paid on the company's common stock, which of the following is true?
The conversion price will be adjusted to $9.09. With a conversion price of $10, the investor was able to convert into 100 shares ($1,000 divided by $10). After the 10% stock dividend, the investor must be able to convert into 10% more shares (110 shares). To get 110 shares from a $1,000 principal, the price must be reduced. The computation is $1,000 divided by 110. That equals $9.09 per share.
A 7% convertible debenture is selling at 101. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be
$25.25. To determine the parity price of the common, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock. (1,010 / 40 = $25.25).
A convertible bond callable at 101 is trading at 105. The bond is a 4% bond convertible at $25. The common stock is trading at $27. If an investor bought the bond and converted, her profit would be A) $20. B) $75. C) $40. D) $30.
$30. First, calculate the number of shares each bond will convert to: $1,000 (par) divided by $25 per share equals 40 shares per bond. With market value at 105, each bond costs $1,050. What is the stock parity price? $1,050 divided by 40 shares equals $26.25 per share. Current market value of the stock minus stock parity price equals profit (or loss). $27.00 − $26.25 = $0.75 per share × 40 shares = $30.
In active trading, a bond of standard size rise in price from 98 5/8 to 101¾. This represents a dollar change of
$31.25 Each point is equivalent to 10 dollars. This bond's price has increased by 3⅛ points. Therefore, the correct answer must be a bit more than $30 (and there is only one choice that is). The exact computation is the $30 for the 3 points plus $1.25 for the 1/8th point.
A customer owns a 7.5% ABC convertible bond currently trading at 115. The conversion price is $40. What is the parity price of the common?
$46.00 The other method to do this is as follows: The bond is selling at a 15% premium. To be equal to that, the stock must be selling at a 15% premium over the conversion price. $40 times 115% equals $46. If that makes sense to you, it is much faster than the first method.
Investors placing zero-coupon bonds in their portfolios are most likely to be looking to provide 1. accumulation of capital. 2. current income. 3. protection against reinvestment risk. 4. tax deferral.
1. accumulation of capital. 3. protection against reinvestment risk
Which of the following statements regarding corporate zero coupon bonds are true? 1. Interest is paid semiannually. 2. The discount is in lieu of periodic interest payments. 3. The discount must be accreted and is taxed annually. 4. The discount must be accreted annually with taxation deferred until maturity.
2. The discount is in lieu of periodic interest payments. 3. The discount must be accreted and is taxed annually.
Which of the following debt securities would be most likely to offer a conversion feature into common stock?
A debenture
An investor seeking income combined with a conservative level of risk would purchase
AA-rated mortgage bonds
Which of the following would be most likely to issue an equipment trust certificate?
An airline company When you see "equipment trust certificate," think transportation companies such as airlines and railroads.
An investor is looking for a fixed-income investment that can provide a reasonable income while offering potential inflation protection. Which of the following would be the best recommendation to meet this investor's objective?
Convertible bonds
With a bearish outlook on the market, an investor would like to purchase something that will generate income now during current bearish conditions but would also be able to take advantage of capital appreciation should market sentiment turn bullish. Which of the following would be a suitable purchase recommendation that puts the investor in a position to do both?
Convertible bonds A convertible bond would generate income from interest payments during the bear market, but if market sentiment becomes bullish, the bond can be converted into common stock, taking advantage of the change in market conditions. None of the remaining choices could fulfill both of these investment objectives.
The GHI Transportation Company has run into decreased sales and is forced into a bankruptcy liquidation. Which of the following would have the most junior claim? A) Holders of GHI's mortgage bonds B) Holders of GHI's collateral trust certificates C) Holders of GHI's equipment trust certificates D) Holders of GHI commercial paper
Holders of GHI commercial paper Secured debt (such as the mortgage bond), the collateral trust certificate, and the equipment trust certificate have first priority in the event of a bankruptcy. Commercial paper is a promissory note relying on the creditworthiness of the issuer.
If a mutual fund's objective is income, it would not hold which of the following securities in its portfolio?
Income bonds
You have a client who is about to retire and wants to rearrange his portfolio to have predictable income. Which of the following would not be a good investment vehicle?
Income bonds Income bonds, also known as adjustment bonds, are issued when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the company has enough income to meet the interest payment.
From first to last, in what order would claimants receive payment in the event of bankruptcy? 1. Holders of secured debt 2. Holders of subordinated debentures 3. General creditors 4. Preferred stockholders
The liquidation order is as follows: secured debt holders, unsecured debt holders (including general creditors), holders of subordinated bonds, preferred stockholders, and common stockholders.
An investor purchases a newly issued convertible bond at par. The bond is convertible at $25. Three years later, the underlying common stock is trading at $33 per share. If the investor sells the bond at the parity price,
there is a long-term capital gain of $320. This question involves several steps. The first is to determine the conversion ratio in shares. A bond convertible at $25 per share has a share conversion rate of 40 shares ($1,000 ÷ $25). The second step is to compute the parity price. That is, what are those 40 shares worth? Multiply 40 shares by $33 per share and that equals $1,320. When the bondholder sells the bonds at parity, that $1,320 is received. The $320 profit over the $1,000 initial cost is a long-term capital gain. An alternative that might be easier for some is to look at the appreciation of the stock. It is $8 per share higher than the conversion price of $25. That represents an increase of 32% (8 ÷ 25). If the bond is at parity with the stock, its price must be 32% higher and that brings us again to the $1,320 price.
Equipment trust certificates are commonly issued by
transportation companies.
An investor interested in acquiring a convertible bond as part of her investment portfolio would
want the safety of a fixed-income investment along with potential capital appreciation.
A commonly used investment to provide a defined sum in the future, such as for college education or retirement, is
zero-coupon bonds.