Preferred Stock

Which statement is TRUE when comparing preferred stock to common stock: A Preferred dividends are paid before common B Both preferred and common stock has voting rights C Preferred shareholders have a junior claim to assets upon liquidation after common shareholders D Preferred interest is paid semi-annually

The best answer is A. Preferred stock has preference over common as to the payment of dividends and as to assets upon liquidation. Preferred dividends (NOT interest) are, in most cases, paid semi-annually, as compared to common stock dividends that are paid quarterly. Preferred stock lacks voting rights.

ABC 8% $100 par preferred is trading at $120 in the market. The current yield is: A 6.7% B 8.6% C 10.6% D 60.6%

The best answer is A. The formula for current yield is: $8 = 6.7%$120

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 $100 while the common stock is trading at $50. If a customer buys 100 preferred shares, converts, and then sells the common stock in the market, the profit or loss is (ignoring commissions): A $0 B $1,000 loss C $5,000 gain D $10,400 gain

The best answer is A. If the customer buys 100 shares of the preferred stock, he or she will pay 100 x $100 per share = $10,000. 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 $50 will yield $10,000. The net profit is: $10,000 - $10,000 = $0. Here, there is a wash, as both the common and preferred are trading at parity.

ABC gold mining company has issued a preferred stock. Dividends on the issue may be paid as: A Cash only B Cash or additional preferred shares of ABC C Cash or additional common shares of ABC D Cash or gold bullion

The best answer is A. 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 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 B $275 C $500 D $550

The best answer is A. 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.

As interest rates fall, preferred stock prices will:. A remain unaffected B rise C fall D fluctuate

The best answer is B. 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 issues $50 par convertible preferred stock, convertible at $10 per share, when the market price of the common is currently $5. Which statement is TRUE? A The conversion ratio is 10:1 B The conversion ratio is 5:1 C The conversion ratio is 2:1 D The conversion ratio cannot be determined

The best answer is B. The conversion ratio is Par Value / Conversion Price. $50 Par / $10 Conversion Price = 5:1 Conversion Ratio.

What type of preferred stock can move in price as the price of the common stock moves? A Straight preferred B Cumulative preferred C Convertible preferred D Participating preferred

The best answer is C. Convertible securities are convertible into common at a predetermined ratio. If the common stock price rises above the conversion price, then the convertible security will trade at the value of the equivalent number of common shares. For example, assume that $100 par common stock is convertible at $20 per share. If the common stock price moves to $25, the preferred must trade for $125, because it is equivalent to 5 common shares. Cumulative preferred means that if the issuer misses dividend payments, these accumulate and must be paid in full before a common dividend can be paid (all preferred is cumulative). Participating preferred gets to participate with common in any "extra" dividends that are declared by the company Board of Directors.

During a period of stable interest rates, which type of preferred stock would show the greatest price volatility? A Cumulative B Adjustable rate C Participating D Callable

The best answer is C. Preferred stock is interest rate sensitive, since it is a fixed income security. As market interest rates rise, preferred stock prices fall. As market interest rates fall, preferred stock prices rise. If market interest rates are stable, preferred stock prices should be stable as well. However, participating preferred stock gives the preferred participation in any "extra" dividends declared by the company to its common shareholders. Thus, the declaration of such an extra dividend would make the preferred stock more valuable and its price would go up in the market - and this did not happen because market interest rates fell. Almost all preferred stock is cumulative - any unpaid dividends accumulate and must be paid before a common dividend can be paid. A call provision can suppress the price of preferred from rising as market interest rates drop, since it is likely that the issuer will call in the preferred and issue new stock at lower current rates. However, during a period of stable interest rates, the call provision has no impact of the preferred stock's price. Adjustable rate preferred moves the dividend rate up or down as market interest rates move up or down. With any variable rate security, the dividend or interest rate moves and the price stays right at par. Furthermore, when interest rates are stable, the dividend rate will not adjust and the price will be stable as well.

Common stockholders and preferred stockholders BOTH have: A voting rights B pre-emptive rights C dividend rights D subscription rights

The best answer is C. Both common and preferred shareholders have the right to receive dividends, if declared by the Board of Directors. Common shareholders have both voting rights and preemptive/subscription rights (the right to maintain proportionate ownership if the issuer issues additional common shares). Preferred stockholders do not have voting rights and do not have preemptive/subscription rights.

Income from which of the following securities is partially tax exempt to a corporate investor? I Common Stock II Preferred Stock III Preferred Stock Mutual Fund IV Convertible Bonds A I only B II and III only C I, II, III D I, II, III, IV

The best answer is C. 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. This tax benefit for corporate investors does not apply to interest received from bond holdings.

If interest rates fall, issuers most likely will call: A all preferred issues B any preferred issue close to maturity C preferred issues trading at a premium D preferred issues trading at a discount

The best answer is C. 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.

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: A tender the preferred shares at the call price B sell the preferred shares at the current market price C sell short the common stock and convert the preferred for delivery to cover the short D continue to hold the preferred shares

The best answer is C. 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.

All of the following are terms associated with preferred stock EXCEPT: A callable B cumulative C redeemable D convertible

The best answer is C. 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.

ABC Company has outstanding 10% noncumulative preferred stock. Two years ago, ABC paid a 6% preferred dividend. Last year, ABC paid a 7% preferred stock dividend. This year, ABC wishes to pay a common dividend. The preferred shareholders must receive: A 0% B 7% C 10% D 17%

The best answer is C. Since this is noncumulative preferred stock, the corporation will only have to pay 10% - or this year's dividend, before paying a common dividend. Please note that virtually every preferred issue is cumulative - noncumulative issues are basically unmarketable. However, noncumulative preferred stock must be known for the exam!

A corporation issues $100 par convertible preferred stock, convertible at $8 per share when the market price of the common is $4. The preferred is issued under an "anti-dilutive covenant." If the company declares a 2:1 stock split, which statements are TRUE? I The conversion price is adjusted to $2 II The conversion price is adjusted to $4 III The conversion ratio is adjusted to 25:1 IV The conversion ratio is adjusted to 50:1 A I and III B I and IV C II and III D II and IV

The best answer is C. 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 $8 per share. If there is a 2 for 1 stock split, the new conversion price will be adjusted to $8/2 = $4 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/4 = 25:1.

Which statement is BEST regarding participating preferred stock? A The dividend rate is fixed B The dividend rate varies depending on the decision of the Board of Directors. C The dividend rate is fixed as to maximum but not as to minimum D The dividend rate is fixed as to minimum but not as to maximum

The best answer is D. Participating preferred pays a fixed dividend rate but also participates with common in "extra" dividends declared by the Board of Directors. Therefore, the dividend rate is fixed as to minimum but not as to maximum.

Which security of the same issuer is likely to give the highest current yield? A warrant B common stock C convertible preferred stock D non-convertible preferred stock

The best answer is D. Warrants give no yield. Common stocks give the lowest yields since there is direct growth potential in the price of the stock as reported earnings increase. Convertible preferred yields are higher than common yields but not as high as non-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.