chapter 1 questions

A corporation has a 9% bond issue outstanding. The bondholder may exchange the bond for 50 shares of the corporation's stock. Which of the following types of bonds is this?

A bond is convertible if the holder has the right to convert the bond into shares of common stock of the corporation.

A convertible bond of the KLP Corporation has a conversion ratio of 20. This means that:

A conversion ratio of 20 means that one bond can be exchanged for 20 shares of common stock. Since the par value of the bond is $1000, this corresponds to a conversion price of $50 per share.

All of the following events would have an upward effect on a corporate bond's market price EXCEPT:

A lower rating for the bond indicates the rating service thinks the company's ability to pay off its debts is less sure. The bond becomes a less desirable investment, and the price drops.

Stockholders can use what type of rights to maintain a proportionate ownership of a corporation?

Preemptive rights give stockholders the right to maintain their proportionate ownership in a corporation.

Jack Smith, in the 35% tax bracket, has an opportunity to buy a 5.3% municipal bond. What corporate yield would provide an equivalent return?

To determine the taxable equivalent yield, divide the tax-free yield by the complement of the individual's tax bracket (1 − the tax bracket %). 5.3% / 65% = 8.153. Note: the corporate bond would have to yield more than the municipal bond to provide the same after-tax return, but not almost triple the return, as called for with the 15.2% corporate yield.

Which of the following characteristics describe Treasury bills?

Treasury bills are issued at a discount and pay all interest at maturity.

An investor desiring safety of principal, modest returns, and having a three-to five-year investment horizon should choose which of the following?

Treasury notes best suit the investor's objective of safety and expectation of modest returns. They have two-to-ten year maturities suitable to his investment time horizon as well.

Which of the following is TRUE of treasury stock?

Treasury stock is stock that has been issued by a corporation and subsequently reacquired in the secondary market. It does not carry the rights of other common shares, such as voting rights, rights to dividends, or preemptive rights.

The holders of which of the following securities are considered owners of the issuing corporation?

Persons who own stock in a company are considered owners; thus, both common and preferred shareholders have ownership (equity) in a corporation. Bondholders are creditors of the corporation. Although convertible bonds convert into shares of common stock, convertible bonds remain a debt of a corporation until they are actually converted.

If interest rates are increasing and the market prices of bonds are decreasing, what happens to the value of straight preferred stock during this period?

Preferred stocks are interest-rate sensitive, as are other fixed- income investment securities, such as bonds. Thus, if interest rates increase, the fixed return may be surpassed by the return provided by other investments. The value of preferred stock will thus decrease when interest rates rise.

Rank the following from first to last in order of payment at liquidation of a corporation.

The complete order of liquidation is as follows: wages, taxes, secured debt, debentures and general creditors, subordinated debentures, preferred stock, common stock.

One of your clients is interested in purchasing a new issue convertible bond. Which of the following statements regarding convertible bonds is NOT true?

The conversion feature allows bondholders to convert their bonds into shares of stock. Increased earnings may have a positive affect on STOCK PRICES and bonds generally offer an investor some downside protection when stock prices are falling. These are all desirable to the bondholder. Adding the desirable conversion feature to the bond allows the issuer to pay a lower coupon rate than they would pay with a nonconvertible bond.

All of the following trade actively in the secondary market EXCEPT:

Warrants, common stock, and options all have an active secondary market. Series EE bonds do not trade; they are redeemable.

A conversion ratio of 20 means that one bond can be exchanged for 20 shares of common stock. Since the par value of the bond is $1000, this corresponds to a conversion price of $50 per share.

In calculating current yield, divide the annual dividend by the current market price. That would be 4 times the quarterly dividend of $.75, or $3, divided by $27, which gives a yield of 11.1%. Capital gains may never be included in a yield calculation.

An income-seeking investor is concerned with the possibility of rising interest rates over the next few years. Of the choices listed, his best investment selection would be:

Long-term maturities have a high degree of interest rate risk. An investor who is looking for income but is concerned with rising rates should invest in short-term instruments such as Treasury bills.

To benefit the economy, business activity needs to increase. Which of the following monetary policy measures might an economist urge the FRB to do?

Lowering the discount rate makes borrowing money cheaper, which will stimulate the economy. Raising or lowering taxes is fiscal policy, not monetary policy.

Which of the following are general characteristics of municipal revenue bonds?

Municipal revenue bonds are backed by revenues generated from the use of the facility that was built with the bond proceeds. General obligation (GO) bonds are backed by the full faith and credit (taxing authority) of the issuing municipality. Because tax dollars are used to pay the debt of GO bonds, municipalities need voter approval to issue them. Revenue bonds do not need voter approval. Finally, municipal issues cannot be deemed safer than U.S. Treasury issues which are backed by the full faith and credit of the federal government.

Which of the following entities are issuers of MUNICIPAL BONDS?

Municipal securities are issued by governments other than the federal government. States, counties, cities, school districts, agencies, and authorities are all examples of municipal issuers.

Which of the following does NOT issue commercial paper?

Municipalities such as a city or state do not issue commercial paper. The commercial paper market was developed so that corporations could lend to, and borrow from, each other more economically.

If a customer has converted his convertible bond into stock, how has his relationship to the corporation changed?

Once a bondholder converts his bonds into stock, he changes from a creditor to an owner of the corporation.

If the FRB decides to tighten the money supply, which of the following would the Fed be most likely to do?

Raising the discount rate discourages borrowers and shrinks the money supply. The FRB has no authority over tax levels. The prime rate and broker call loan rate are determined by banks in competition with each other, not the FRB.

A municipal bond has a coupon of 6.25% and at the present time, its yield to maturity is 6.75%. From this information, it can be determined that the municipal bond is trading:

The YTM is greater than the nominal yield, or coupon yield. Therefore, the bond is trading at a discount.

If ABC common stock closed at 20 yesterday and ABC is currently paying a quarterly dividend of $.40, what is the stock's current yield?

The annual dividend is $1.60 (4 × $0.40). The current yield is the dividend of $1.60, divided by the current price ($20). Thus, the yield of 8% is more than 5% (1/20) and less than 10% (2/20).

A client invests $10,000 into a large-cap growth fund. Five years later, the account value is $15,000. At the same time, the CPI has increased 25%. In terms of constant (real) dollars, the client's account is worth:

The client's account has appreciated by 50%, but the CPI has increased by 25%. In order to measure real growth, we must factor in that increase to the cost of living so the account would now have a value, in constant dollars, of something between $10k and $15k.

Annual interest payment divided by current dollar price of a bond is the:

The current yield is the annual interest (in dollars) divided by the bond's market price (in dollars).

Banks pay the federal funds rate for:

The federal funds rate is the rate of interest at which banks may borrow excess funds from other banks, usually on an overnight basis.

The interest on which of the following instruments is subject to taxation at the federal, state, and local levels?

The interest on corporate debt securities is subject to taxation at the federal, state, and local levels, and collateralized mortgage obligation (CMOs) are issued by corporations. Interest on Treasury instruments is taxable at the federal level only. Interest on municipal instruments is exempt from taxation at the federal level and possibly the state level if the holder is a resident of the state of issue. Public HOUSING AUTHORITY bonds and revenue bonds are types of municipal issues, which are tax free at the federal level.

Transactions in all of the following are effected in the money market, as opposed to the capital market, EXCEPT:

The money market is the marketplace for short-term (one year or less) debt obligations. The capital market is where long- term capital is raised. MUNICIPAL BONDS, being long term, are a part of the capital market.

Which of the following terms apply to options?

The premium is the cost of an option contract, expressed in dollars per share of the underlying stock. The strike price is the price at which the stock will be bought or sold if the contract is exercised, also expressed in dollars per share.

An investor makes a purchase of common stock at a cost of $1,000. He holds the stock for one year and sells it for $1,500. During the same time, the Consumer Price Index increases by 7%. As a result of this increase, the value of the investment in constant dollars at liquidation would be:

The value of the individual's investment will be greater than $1,000 but less than $1,500 in terms of constant dollars, because inflation reduced the value of the $500 capital gain.

During the past two quarters, the GDP declined by 3%, unemployment rose by .7%, and the Consumer Price Index fell off by 1.3%; this economic condition is called:

Two consecutive quarters of economic decline is termed a recession.

A new bond issue may include warrants to:

Warrants are used as sweeteners to increase a new bond issue's attractiveness to the public. With warrants, the bonds can generally be offered with a lower coupon rate than would otherwise be acceptable to investors.

A bond offered at par has a coupon rate:

When a bond is selling at par, its coupon or nominal rate, current yield, and yield to maturity are all the same.

When the value of the U.S. dollar appreciates, which of the following is TRUE?

When the U.S. dollar increases relative to other currencies, the U.S. dollar purchases more foreign goods and foreign currencies purchase fewer U.S. goods. Therefore, travel abroad and foreign goods cost less while U.S. exports decrease as U.S. goods become more expensive to foreign purchasers

A company currently has earnings of $4 and pays a $.50 quarterly dividend. If the market price is $40, what is the current yield?

...

Every corporation must issue what kind of stock?

A corporation, according to its charter, must issue voting common stock. Thereafter, the corporation is free to issue other securities.

T-bills are direct obligation of the US government and

T-bills are short-term obligations and, unlike most other debt securities, are issued at a discount from par. Once they are issued, T-bills trade in the secondary market.

All of the following are advantages of investing in American Depositary Receipts (ADRs) EXCEPT:

ADRs carry currency risk because distributions on ADRs must be converted from foreign currency to U.S. dollars on the date of distribution. In addition, the trading price of the ADR is affected by foreign currency fluctuation.

Owners of American depositary receipts enjoy all of the following benefits EXCEPT

Although ADR owners do receive their dividends in dollars and can purchase and sell the security in dollars, they do not avoid currency risk. ADRs also do not carry voting rights.

Which of the following statements regarding Treasury bills are TRUE?

T-bills are sold at a discount and mature in 4, 13, 26, or 52 weeks. Although they mature at face value, they do not make interim interest payments.

What is the conversion ratio of a convertible bond purchased at par value and convertible at $50?

The $1,000 par value divided by the $50 conversion price equals 20 shares per bond.

Which of the following bonds qualify as municipal bonds?

Any bond issued by a state, municipality, or governmental unit other than the federal government or one of its agencies is categorized as a municipal issue.

An investor who desires minimal credit risk and monthly interest income should consider an investment in which of the following?

Because Government National Mortgage Association (GNMA) pass-through certificates are guaranteed by the U.S. government, investors who purchase them face no credit risk. Income from GNMA is paid to the investor on a monthly basis.

What would happen to the market value of existing bonds during an inflationary period coupled with rising interest rates?

Bond prices fall when interest rates rise because bond prices have an inverse relationship with interest rates.

The most comprehensive measure for comparison of bond yields is the:

Bond yields are most accurately compared by their yield-to-maturity. The yield-to-maturity reflects annualized gains and losses based on both interest and the average price of the bond from time of purchase until maturity.

Which of the following securities are issued with a fixed rate of return?

Bonds and preferred stock usually are issued with a stated payment, either in interest or dividends. Common stockholders are entitled to receive a variable distribution of profits if and when a dividend is declared. Warrants do not pay dividends.

Net worth in a corporation includes all of the following EXCEPT:

Common and preferred stock are considered evidence of ownership in a corporation and thus are part of net worth, or shareholders' equity. Bonds represent debt, and are listed with the long-term liabilities, rather than the net worth.

Rank the following in ascending order (from low to high) of their claims against a corporation's assets when it is forced to liquidate.

Common stock has the lowest claim on assets, preceded by preferred stock and debentures. Secured bondholders have the greatest claim among those given to company assets in the event of dissolution.

When trading common stock, either at an exchange or over the counter, the standard size of the trading unit is

Common stock trades in round lots of 100 shares each.

In general, a corporation assumes the least risk when it obtains funds from the:

Remember that issuing equities is less risky than issuing debt because when issuing debt, the issuer is obligated to pay the creditor back! When issuing equities such as preferred stocks, the issuer has no obligation to ever pay any of the money back and therefore is less risky for the issuer.

Which of the following statements are NOT true concerning revenue bonds?

Revenue bonds are not secured by a specific pledge of property and are not a type of general obligation bond. They are secured by user fees, such as tolls.

Which of the following is a debt instrument that pays no periodic interest?

STRIPS are Treasury bonds with the coupons removed. STRIPS do not make regular interest payments. Instead, they are sold at a deep discount and mature at par value.

LMN's trading volume for yesterday was reported as 178. The number of SHARES TRADED was:

Shares are reported in round lots, which are 100 shares each 178 × 100 shares = 17,800.

The interest from which of the following bonds is subject to federal income tax?

Direct federal debt, such as a Treasury note, is subject to federal income tax but exempt from state tax. FNMA bonds are subject to federal, state, and local taxes. State and city bonds, being municipals, are exempt from federal income tax.

Which of the following is a SRO?

FINRA is the primary Self Regulatory Organization (SRO) in the securities industry.

An investor has secured bonds maturing in two weeks. He plans to purchase some unsecured bonds he has identified on the secondary market that have a 6% coupon rate. If interest rates decline before the investor can purchase the new bonds, he can expect the income he will receive from the new bonds to:

Fluctuations in interest rates will affect a bond's price, but will not affect the bond's payable interest. The percentage interest payable for use of money is stated on the face of a bond and is part of the bond indenture, a legal obligation on the part of the issuing company.

A CMO makes an interest-only payment to an investor. This payment will be:

Interest-only payments made by CMOs are taxed as ordinary income.

Which of these rates is the most volatile?

The federal funds rate, which changes at least daily, is the most volatile of the rates given.

TIPS offer which of the following benefits to an investor?

Treasury Inflation Protection Securities (TIPS), are issued by the government and designed to offer investors inflation protection by adjusting the principal of the TIPS semiannually based on the Consumer Price Index (CPI). No security guarantees a profit upon sale and only an annuity can guarantee an income for life.

Common stockholders of a publicly traded corporation have which of the following rights and privileges?

Common stockholders of publicly traded companies have a residual claim to assets of a corporation at dissolution and are entitled to receive an annual report containing audited financial statements. Stockholders never get to vote on dividends.

Which of the following best describes book entry?

For book-entry ownership, transfers of ownership are accounting functions in the records of the issuer or the issuer's transfer agent, since it is the issuer, not the SRO or the clearing agency, that must pay the interest and eventually the bond's principal.

There are a number of risks inherent in investing in equity securities. Which of the following stocks would be most affected by changes in interest rates?

For most investors, the primary feature of investing in preferred stock is its fixed dividend. Consequently, it is purchased for income and is more sensitive to changes in interest rates than common stock is. Warrants are not affected by interest rate movement as they only provide a right to purchase underlying common stock.

All of the following debt instruments pay interest semiannually EXCEPT:

Ginnie Maes pay interest on a monthly basis, not semiannually.

A customer owns cumulative preferred stock (par value $100) that pays an 8% dividend. Dividends have not been paid this year or for the 2 previous years. How much must the company pay him per share before it can pay dividends to the common stockholders?

If the company is going to pay a common stock dividend, it must pay the preferred dividends first. A cumulative preferred stockholder must also receive all dividends in arrears. There are $16 in back dividends due in addition to $8 this year, for a total of $24.

Which of the following statements regarding a two-for-one stock split are TRUE?

In a two-for-one stock split, the number of outstanding shares is doubled and the price is halved. The total market value of the issuer's stock therefore remains the same.

An investor in the 28% income tax bracket is considering purchasing either a 4% municipal bond or a 5% corporate bond. Which of the following statements regarding the two bonds after-tax yields aid TRUE?

Investors should invest in municipal bonds if the return after taxes is higher than comparable taxable bonds. To compare the two bonds, use the tax-free equivalent yield formula: (taxable yield)x(100%-tax-bracket)=(tax-free equivalent yield). In this case, 5% x (100% - 28%) =5%x.72=3.6%. Because the municipal bond yields 4% tax free, the investor should buy it; after taxes have been paid, the cooperate bond yields only 3.6%.

Which type of marketable security pays semiannual interest?

Marketable securities are traded in the secondary market. T-bonds are marketable debt and pay interest semiannually. Series HH and EE bonds are not marketable. Treasury bills issue at a discount and mature at par.

Which of the following are characteristics of negotiable jumbo CDs?

Negotiable jumbo CDs are issued for $100,000 to $1 million or more and trade in the secondary market. Most jumbo CDs are issued with maturities of less than a year. The FDIC INSURES only up to $250,000.

Which of the following is within the power of the FRB?

The Federal Reserve Board (FRB) determines monetary POLICY through changes in reserve requirements;changes in the discount rate (on loans to member banks); and open-market operations (buying and selling Treasury securities). Fiscal policy refers to legislative decisions of Congress and the President, which basically involves the ability to tax and spend.

The best time to purchase shares in a long-term bond fund is:

The best time to purchase shares in a long-term bond fund is when interest rates are falling after a period of high rates. The bonds already in the fund will continue to pay a high rate of return, and if rates continue to fall, the market value of the fund's portfolio will rise.

If all other factors are equal, an investor would expect which type of preferred stock to pay the highest stated dividend rate?

When the stock is called, dividend payments are no longer made. With callable preferred stock, to compensate for that possibility, the issuer pays a higher dividend than with straight preferred. Cumulative and convertible preferred have positive characteristics that would justify a lower fixed dividend than straight.