S7 UNIT 4 Quizzes (Corporate Bonds)
When analyzing a convertible debt security, it is most likely the issue is A) a debenture. B) a convertible preferred stock. C) a zero-coupon security. D) a bond.
A) a debenture. Explanation We are being very picky with the wording here. The most specific response is a debenture. In most cases, convertible debt issues are unsecured. That defines them as debentures. Note that preferred stock is not a debt security; it is equity. LO 4.c
A convertible debenture callable at 101 is trading at 105. The debenture carries 4% coupon and is convertible at $25. The common stock is trading at $27. If an investor bought the debenture and converted, the profit would be A) $30. B) $20. C) $40. D) $75.
A) $30. Explanation As is the case with many math questions, there is more than one way to arrive at the correct answer choice. We'll show you two of them for this question and you can use whichever method is easiest for you. First, calculate the number of shares the investor will receive upon conversion of the debenture: $1,000 (par) ÷ $25 per share conversion rate = 40 shares per debenture. With the market price at 105, each debenture costs $1,050. What is the parity price of the stock? $1,050 ÷ 40 shares = $26.25 per share. That is, when the common stock is selling at $26.25 per share, the 40 shares received upon conversion are equal to the same $1,050 as the debenture; this is what parity is all about. If we subtract the parity price of the stock ($26.25) from the current market price of the stock ($27), we see there is a profit of $0.75 per share. Converting into 40 shares at a profit of $0.75 per share results in a total profit of $30. Alternatively, knowing that the debenture is convertible into 40 shares of common stock, with the current market price of that stock at $27 per share, those 40 shares could be sold for $1,080 (40 × $27). If the debenture can be purchased for $1,050 (105) and then converted into $1,080 worth of stock, the investor profits by $30. Please note that, as is the case with many calculation questions, there is information supplied that is totally irrelevant to solving the problem. In this question, the fact that the debenture is callable and pays interest at a rate of 4% has nothing to do with determining the investor's profit following the conditions given. LO 4.d
Your new client lists income as the primary investment objective for an account with your broker-dealer. Which of the following investments would not be suitable? A) Zero-coupon bonds B) Corporate debt securities C) Ginnie Mae government securities D) Corporate preferred shares
A) Zero-coupon bonds Explanation Zero-coupon bonds make no payments until maturity, and therefore, would not be suitable investments for those with an income objective. Typically, preferred shares (because of the fixed dividend they pay) and corporate or government securities, which make interest payments, would be suitable investments to meet an income objective. LO 4.a
An investor purchased a corporate zero-coupon bond on the offering at a price of 51. The bond matures in 17 years and has a yield to maturity of 4.04%. Seven years later, the bond is sold at a price of 73 ¾. What are the tax consequences of the sale? A) Gain of $25.76 B) Gain of 227.50 C) No gain or loss until maturity D) Loss of $262.50
A) Gain of $25.76 Explanation The amount of the discount is $490 ($1,000 − $510). This must be accreted over the 17 years until maturity. The annual accretion is $28.82 ($490 ÷ 17 years). After seven years, there is $201.74 of accretion (7 × $28.82). Because the annual accretion is added to the investor's cost basis, the basis is now $711.74 ($510 + $201.74). The bond's sale price of $737.50 is $25.76 above the accreted basis, meaning a gain of $25.76. The yield to maturity has nothing to do with the question. LO 4.e
A bond was issued three years ago with a coupon of 8%. The bond matures in four years and is callable at 108. Current market interest rates are 6%. Which of the following is true? A) The bond is selling at a premium. B) The bond is selling at a discount. C) The coupon will be adjusted. D) The bond will be called.
A) The bond is selling at a premium. Explanation Simply, this is a bond where interest rates have gone down since it was issued. When interest rates go down, bond prices go up. Although the call feature can be beneficial when money is available to borrow at lower rates, the combination of the short term to maturity and the relatively high call price are unlikely to make it worth the underwriting expense. In any event, that is only a possibility, while the fact that the bond will be selling at a discount is a virtual certainty. LO 4.a
A convertible bond has a conversion price of $50 per share. If the market value of the bond rises to a 10-point premium over par, which of the following statements is true? A) The conversion ratio is 20:1 with parity price of the common stock at $55. B) The conversion ratio is 22:1 with parity price of the common stock at $60. C) The conversion ratio is 22:1 with parity price of the common stock at $55. D) The conversion ratio is 20:1 with parity price of the common stock at $60.
A) The conversion ratio is 20:1 with parity price of the common stock at $55. Explanation Regardless of the price of the bond, the conversion ratio will always be 20:1 because $1,000 divided by $50 is 20. Parity means equal. Therefore if the bond is at a 10% premium ($1,100), the parity value of the stock will be $55 ($1,100 ÷ 20). LO 4.d
Libby sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 7¼% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Libby's concerns about the issue could include which of the following? A) The issue may have a junior claim to another security issue. B) The new barges might sink, and the collateral would be gone. C) She should not be concerned, as the bonds will be first in liquidation. D) The company might demand that she accept common stock for her bond.
A) The issue may have a junior claim to another security issue. Explanation The word subordinated is the key to the question. A subordinated bond has other debt holders ahead of it in the event of liquidation. The barges do not serve as collateral, as the bonds are identified as debentures, and having to convert to common stock is not a threat because she is the one that will, if she desires, exercise the conversion privilege. LO 4.b
Which of the following best describes a debenture? A) Unsecured corporate debt B) An investment in the debt of another corporate party C) A long-term corporate debt obligation with a claim against securities rather than against physical assets D) A corporate debt obligation that allows the holder to purchase shares of the company's common stock at specified dates before maturity
A) Unsecured corporate debt Explanation A debenture is unsecured corporate debt. LO 4.a
THX, a new expanding technology company, is planning to raise capital and seeks the advice of Vorn Capital Investment Bank about the best way to raise the money. Current economic conditions seem to be worsening, interest rates are rising, and the equity markets are bearish. According to the managing underwriter, the best strategy for issuance of securities would be to A) issue convertible bonds to reduce the financing costs to the corporation but also attract investors who might see the possibility of getting growth when the equity markets rebound. B) issue only preferred stock because investors would be attracted to the higher potential for dividends than are offered by common stock. C) issue corporate zero-coupon bonds at a discount because there would be no interest payments that need to be made, saving the corporation from paying interest on their debt.
A) issue convertible bonds to reduce the financing costs to the corporation but also attract investors who might see the possibility of getting growth when the equity markets rebound. Explanation First, we should look at this scenario from the perspective of the issuer and not the investors. Due to the high-interest-rate environment and the bearish sentiment of the equities market, it would be more difficult to raise capital by issuing equity securities. This is why in down markets offerings of equity securities get delayed or postponed. It would be easier to attract investor money by issuing debt because of the possibility of income for the investors. Zero-coupon bonds would not be a good choice because the new company would not raise as much capital because the bonds would be sold at a deep discount but the total debt liability of paying all the debt would remain on the balance sheet. Convertible bonds could be sold for par value, but the attractive feature of conversion to stock also reduces the interest financing costs to the new corporation as well while making them more marketable. Additionally, if the bonds eventually get converted to stock, the debt burden of the new and growing company would also be reduced. In theory, because the conversion price would also have been higher than the potential market price of the stock, the issuer would ultimately have sold the converted stock for more than what the stock would have been sold for in the bearish market. LO 4.c
n investor purchased a zero-coupon corporate bond on the initial offering. The price was 50. The bond's maturity date is in 10 years. At maturity, this investor will have A) no taxable capital gain. B) no taxable income and a $500 long-term capital gain. C) $500 in taxable income and no capital gain. D) a combination of taxable income and capital gain based on IRS tables.
A) no taxable capital gain. Explanation On a corporate zero-coupon bond, investors must accrete the interest on an annual basis. Investors receive a Form 1099-OID indicating the amount of taxable accretion earned for the year. This is known as phantom income because it is taxed but not received. This phantom income is one of the reasons why these bonds are favored for tax-sheltered accounts, such as IRAs. Because all the interest has been accreted, when the bond matures, there is no capital gain or loss. LO 4.e
Joe Johnson is a founding partner of Ground Break Realty. The company was impacted negatively by rising interest rates and falling property values. There was concern that the firm needed an injection of liquidity to prevent failure, and Johnson lent the company funds to forestall bankruptcy. If the company goes bankrupt, Johnson will A) receive his loaned money before any of the equity investors in the company. B) receive his loaned money first over any other investor because he is a founder of the company. C) receive his money after the secured creditors but before the holders of standard debentures. D) not receive any money back because he is an owner of the company, and the loaned money is considered equity (the money represents an equity interest in the company).
A) receive his loaned money before any of the equity investors in the company Explanation It is not uncommon for founders of companies to lend money to the business to keep the company going. However, this is typically subordinated debt. Subordinated debt has priority over equity investors but goes behind all other creditors including unsecured debt such as debentures. LO 4.b
Which of the following would be most likely to issue an equipment trust certificate? A) A social media company installing new servers B) An airline company C) A user of farming equipment D) A company using specialized equipment on an oil drilling rig
B) An airline company Explanation When you see "equipment trust certificate," think transportation companies such as airlines and railroads. LO 4.a
What action could a corporation take that would result in the forced conversion of an outstanding convertible debt security? A) Reduce the dividends on the common stock to a rate lower than the interest on the debt security B) Exercise the call feature when the debt security's conversion value exceeds the call price C) Exercise the conversion feature when the debt security's conversion value exceeds the call price D) Reduce the coupon rate below the dividend rate on the common stock
B) Exercise the call feature when the debt security's conversion value exceeds the call price Explanation One of the investor benefits of a convertible security is that an increase in the market price of the underlying common stock will lead to a comparable increase in the price of the convertible. For example, when the market price of the common stock is $25 per share, a $1,000 convertible debenture with a conversion ratio of 50 shares per bond has a conversion value of $1,250 (50 shares times $25 per share). Because most convertibles are also callable, by calling the bonds at the stated call price (perhaps 102 or 103) the company can force the bond holders to convert the bonds. Using our example, why would investors hold onto the bonds knowing that, within about 30 days, they're going to get a check for $1,020 or so for each bond when they could convert and own shares worth $1,250 per bond. This is known as forced conversion. The coupon rate is fixed, and an investor would not want to convert to the stock just because the dividends on the stock are lower than the interest on the bond. LO 4.c
Which of the following is not considered a debt security? A) Promissory note B) Prior lien preferred stock C) Equipment trust certificate D) Debenture
B) Prior lien preferred stock Explanation Stock, whether preferred or common, represents equity (ownership) and is never considered a debt security. The most common example of a promissory note on the exam is commercial paper, a money market instrument. Debentures represent an unsecured debt of the issuer. Equipment trust certificates represent debt secured by specific equipment, typically rolling stock. LO 4.a
A large national grocery chain owns several smaller regional supermarkets. The regional chain that operates in Chicago is experiencing some economic hardship, and the chain gets its debt downgraded by Standard & Poor's. The chain is desperate to raise capital to deal with a lack of cash flow. What method would be the best for raising capital? A) The regional chain should issue secured mortgage bonds to investors because the investors would be guaranteed to get their money back even if the regional chain defaults. B) The regional chain should seek to get their parent company to support them through the issuance of guaranteed bonds which although unsecured would be safer than direct debenture of the struggling chain.. C) The regional chain should issue high-yield corporate bonds to attract investors because they are safer than issuing stock to the investors if the company defaults.
B) The regional chain should seek to get their parent company to support them through the issuance of guaranteed bonds which although unsecured would be safer than direct debenture of the struggling chain. Explanation Although it is true that high yield (junk) bonds have a higher priority than stockholders in a default, it is not the best answer. Due to the fact the regional chain has a larger parent company, it would be more likely to raise capital through the parent company by the issuance of guaranteed debt which is actually unsecured but would normally have a higher credit rating than the distressed smaller company. Mortgage bonds, although secured, do not guarantee that investors would get back all their money as the underlying property might be distressed and be of lower value when liquidated. LO 4.b
A bond convertible at $50 is selling at 105% of parity, while the common stock has a current market value of $45. What is the market value of the bond? A) $1,045 B) $1,000 C) $945 D) $900
C) $945 Explanation When a bond is convertible at $50, it means the holder can exchange each $1,000 par value bond for the company's common stock at a rate of $50 per share. Dividing $1,000 (always use the par value, not the market value) by $50 results in a conversion rate of 20 shares per bond. With the bond convertible into 20 shares and the market price of each share currently $45, the parity price, the price at which the value of the stock and the bond are the same, is $900, (20 × $45). The question tells us that the bond is selling for 105% of the parity price. That would be $900 × 105% = $945. An alternative method is to recognize that the stock is selling for 10% below its conversion price ($45 is $5 less than $50 and $5 ÷ $50 = 10%). That means the parity price of the bond must be 10% below the par value, or $900 (which is 10% less than $1,000). Once you have the $900, multiply by 105% to arrive at the correct answer of $945. LO 4.d
From first to last, in what order would claimants receive payment in the event of corporate bankruptcy? I) Holders of secured debt II) Holders of subordinated debentures III) General creditors IV)Preferred stockholders A) III, I, II, IV B) IV, I, II, III C) I, III, II, IV D) I, II, III, IV
C) I, III, II, IV Explanation The liquidation order is as follows: secured debt holders, unsecured debt holders (including general creditors), holders of subordinated bonds, preferred stockholders, and common stockholders. LO 4.b
An investor purchased 20 XYZ Corporation 6s convertible bonds for 97 that mature in 20 years. The bonds are convertible into 40 shares. However, three years after the purchase, the corporation declared a 20% stock dividend when the bond was trading for 105. Then six months later, the investor decided to convert the bonds which were then trading at 104 into stock and sell the common shares which are trading were parity. What is the capital gain or loss on the bonds and the conversion price of the shares? A) Short term capital gain of $1,400 and conversion price of $21.875 B) Long term capital gain of $2,000 and conversion price of $26.00 C) Long term capital gain of $1,400 and conversion price of $20.83 D) Short term capital loss of $2,000 and conversion price of $25.00
C) Long term capital gain of $1,400 and conversion price of $20.83 Explanation Holding periods of convertible securities are based on the original investment and not on when they get converted. The converted stock would have the same holding period as the original convertible bonds which is more than three years so the capital gain would be long term. The original conversion price of the bond was $25 because the conversion ratio was 40 shares: ($1,000 par ÷ 40 shares = $25). However, the original cost basis per share was based on the price paid for the bond, $970. Dividing by the 40 shares makes the original cost basis $24.25 per share. The 20% stock dividend increased the number of shares from 40 to 48 shares, but then the cost basis must be adjusted as well: $970 ÷ 48 shares = $20.21 adjusted cost basis. The conversion price would be based upon par $1000 ÷ 48 shares = $20.83 conversion price. When the investor converted the bonds into stock, the market value of the bond was $1,040. To get the parity value of the common shares, divide the market value of the bond by the new conversion ratio: $1040 ÷ 48 shares = parity price per share of $21.67. Thus, the gain per share is $1.46 ($21.67 − $20.21). Multiply by the 48 shares per bond and then the 20 bonds so 960 × $1.46 is approximately $1,400. LO 4.c
Corporate bonds that are guaranteed are A) required to maintain a self-liquidating sinking or surplus fund. B) insured by Assured Guaranty Corporation. C) guaranteed as to payment of principal and interest by another corporation. D) guaranteed as to payment of principal and interest by the U.S. government.
C) guaranteed as to payment of principal and interest by another corporation. Explanation A guaranteed corporate bond is one guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it. LO 4.a
If ABC Corporation reports a loss for the year, it is obligated to pay interest on all of the following debt securities except A) debentures. B) cumulative preferred stock. C) income bonds. D) convertible bonds.
C) income bonds. Explanation Even if a corporation reports a loss, the corporation is obligated to pay interest on all its outstanding debt except for income (adjustment) bonds. Income bonds require payment of interest only if ABC has sufficient earnings, and the board of directors declares payment of the interest. Preferred stock is not a debt security. LO 4.a
With the advent of the horseless carriage (a.k.a. the automobile), the Acme Buggy Whip Corporation's revenues fell to the point where it could no longer cover expenses. This led to an involuntary bankruptcy. The priority of payout was A) common stock, preferred stock, general creditors, senior notes. B) general creditors, senior notes, preferred stock, common stock. C) senior notes, general creditors, preferred stock, common stock. D) senior notes, preferred stock, common stock, general creditors.
C) senior notes, general creditors, preferred stock, common stock. Explanation Senior debt refers to obligations that have priority in the event of default. It parallels the use of senior when comparing preferred stock to common stock, the most junior of all securities. LO 4.b
In active trading, a bond of standard size rises in price from 98 5/8 to 101¾. This represents a dollar change of A) $312.50. B) $3.125. C) $0.3125. D) $31.25.
D) $31.25. Explanation Let's take this step by step remembering that every point in a bond quote equals $10 and every 1/8 of a point equals $1.25 ($10/8 = $1.25). Method #1 1) The increase is 3 1/8 points (101 ¾ minus 98 5/8 = 101 6/8 − 98 5/8 = 3 1/8 2) 3 1/8 = $30 (3 times $10 per point) + $1.25 which equals $31.25 Method #2 1) 101 3/4 = 101 × $10 = $1,010 + 3/4 of $10 = $7.50, total price is $1,017.50. 2) 98 5/8 = 98 × $10 = $980 + 5/8 of $10 = $6.25. total price is $986.25. 3) The difference between the two prices is $1,017.50 − $986.25 which = $31.25. LO 4.d
An investor purchases zero-coupon bonds issued by the U.S. Treasury due to mature in 18 years at $100,000. Which of the following might describe the primary reason for selecting that investment vehicle? I) The investor is 65 years old and needs the reliability of current income. II) The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement. III) The investor is 30 years old and has a newborn child and wishes to assure funds for a college education. IV) The investor is 20 years old, has just received an inheritance, and wishes to shelter income for as long as possible. A) III and IV B) I and II C) I and IV D) II and III
D) II and III Explanation Zero-coupon bonds maturing in 18 years would assure the 45-year-old of the face value at age 63. Being in an IRA, there would be no current taxation, and upon maturity, if desired, the funds could be distributed without the 10% penalty. Zero-coupon bonds are one way to guarantee funds for college education. However, with no current income, they would not be suitable for the 65-year-old and would not offer any tax shelter to the 20-year-old. LO 4.a
An investor wants to maximize income using debt securities. Which of the following lists rank securities from the least suitable to the most suitable recommendation if income is the investment objective? A) Convertible bond, income bond, nonconvertible bond B) Nonconvertible bond, convertible bond, income bond C) Treasury bills, convertible bond, income bond D) Income bond, convertible bond, nonconvertible bond
D) Income bond, convertible bond, nonconvertible bond Explanation The income (or adjustment) bond is the least suitable because it is issued by companies coming out of bankruptcy with interest payable only if the money is available. Therefore, it is not suitable given the objective. A convertible bond has a lower coupon than a nonconvertible bond because of the convertibility feature. Therefore, if seeking to maximize income, the corporate bond would be the most suitable of the three choices (from least to most: income bond, convertible bond, and nonconvertible bond). LO 4.a
Betco Corporation had insufficient liquidity to meet its outstanding debt and was subsequently forced into bankruptcy. There were numerous lawsuits from all of the various creditors and investors against the corporation. Finally, a court settlement was reached to dissolve the company and use the remaining assets to pay off the creditors. Who most likely has the highest priority of getting paid? A) Investors holding guaranteed bonds because guaranteed bonds provide an ironclad guarantee that the investors always get back the principal amount invested B) The secured creditors because secured debt is always the most senior security C) The senior executives of the corporation because being senior executives gives them the most senior claim to corporate assets D) The attorneys representing the plaintiffs in the lawsuits against the bankrupt company
D) The attorneys representing the plaintiffs in the lawsuits against the bankrupt company Explanation Normally, secured debt would have the highest claim. However, when legal issues involve judicial suits, those involved in resolving the bankruptcy would not work on the case unless they would get paid. As a result, the courts usually require administrative expenses to be paid prior to even the secured creditors. Guaranteed bonds are still a form unsecured debt and would not have seniority over secured debt. Executives of the company would only have claims based upon unpaid compensation and in most cases, they would tend to fall under general creditor status. LO 4.b
ABC Corporation has an outstanding 8% convertible bond that is callable at 102. Currently, the bond is trading at 101. The conversion price is $40, and the common stock is currently trading at $39.50. ABC announces a call at 102. To realize the greatest profit, a bondholder should A) convert the bonds into common and sell the converted shares. B) continue to hold the bonds and receive interest payments. C) sell the bonds at the current market price. D) tender the bonds.
D) tender the bonds. Explanation The investor would realize the greatest sales proceeds by tendering the bond to the corporation for 102. Selling the bond at its current market value of 101 is not an attractive option. Converting the bond to common stock would result in 25 shares ($1,000 par converted at $40 = 25 shares) sold at $39.50 per share ($39.50 × 25 = $987.50). Once the call date passes, the issuer ceases interest payments making it unattractive to continue to hold the bonds. LO 4.d
An investor interested in acquiring a convertible bond as part of her investment portfolio would A) be interested in tax advantages available to convertible debt securities. B) want the assurance of a guaranteed dividend on the underlying common stock. C) seek to minimize changes in the bond price during periods of steady interest rates. D) want the safety of a fixed-income investment along with potential capital appreciation.
D) want the safety of a fixed-income investment along with potential capital appreciation. Explanation An investor who wants the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible bond. However, because convertible bonds can be exchanged for common stock, their market price tends to be more volatile during times of steady interest rates than other fixed-income securities. LO 4.c
A corporation has an outstanding issue of 8% convertible debentures with a conversion price of $25. The bond indenture contains an antidilutive clause guaranteeing the debt holders the right to maintain proportionate equity conversion in the corporation. If the company pays a 10% stock dividend to its common shareholders, how will that affect the debenture holders? A) They will receive four shares of the common stock. B) The bonds will now be convertible at approximately 22.73. C) Each debenture holder will receive a check for $100. D) The interest rate on the debentures will increase to 8.8%.
Explanation The antidilutive provision means the debenture holders will be able to convert into an equivalent share value as before. With a conversion price of $25, the bond is convertible into 40 shares ($1,000 ÷ $25). After the 10% stock dividend, they should be able to have 10% more shares, or 44 shares. That means the conversion price must be reduced. Divide $1,000 by 44 shares and the result is $22.73. Remember, anytime there is a stock dividend, prices go down. LO 4.c