Unit 11

Liquidation priority

1. Secured creditors 2. Unsecured creditors 3. Subordinated debt holders 4. Preferred stockholders 5. Common stockholders

The MNO Manufacturing Company, headquartered in Springfield, has just filed for bankruptcy. Under federal bankruptcy law, which of the following would have highest priority with the bankruptcy trustee? A) Holders of mortgage bonds B) Property taxes owed to the city of Springfield C) Employee wages earned within the 180 days prior to the bankruptcy filing D) Holders of first lien, senior preferred stock

A. Holders of mortgages on real property securing a bond are senior creditors and have the highest priority claim in a bankruptcy. Under federal bankruptcy law, there are several categories of unsecured claims that have a higher priority than other unsecured ones, but secured debt always comes first. Two of the most common high ranking unsecured claims are employee wages as long as the wages were earned during the 180 days prior to the bankruptcy filing, and certain taxes. No matter how many adjectives are placed ahead of preferred stock, it always comes after everyone who is owed money.

Which of the following will be the most likely risk that you will face during the first year after purchasing a corporate AA bond that matures in 15 years? A) Market B) Interest rate C) Inflation D) Liquidity

B. With 15 years to maturity, even an investment-grade bond is subject to interest rate risk. This is particularly true during the early years because price fluctuations are greater when duration is longer. Inflation risk is not very great over a period of only 1 year, and AA bonds generally possess better-than-average liquidity. For this exam, market risk usually applies to equity securities rather than debt.

As interest rates rise, the opportunity cost of holding cash A) increases. B) equals the risk-free rate. C) decreases. D) remains the same.

C. At higher interest rates, the opportunity cost of holding cash increases, and firms and households will desire to hold less cash and more interest-bearing financial assets.

An agent for a well-known broker-dealer has taken it upon herself to look for investment opportunities for her clients. Her research indicates that, in spite of record earnings, the stock of GEMCO, Inc., is poised for a price reversal. Should this analysis prove correct, this would be an example of A) financial risk B) regulatory risk C) market risk D) reinvestment risk

C. Market risk is the uncertainty that the market price of a stock will drop even when earnings are strong. Most stocks follow the "market" and this would appear to be no exception. Financial risk concerns itself with financing, particularly debt, so it is related to credit risk. Nothing in this question infers anything about financing difficulties.

Liquidity risk would be greatest for an investor whose portfolio was primarily composed of A) municipal bond UITs B) Nasdaq stocks C) ADRs listed on the NYSE D) municipal bonds

D. Any stock listed on the NYSE or traded on Nasdaq has high liquidity. Municipal bonds tend to be thinly traded, thereby exposing their holders to a higher degree of liquidity risk. UITs, regardless of their portfolio, stand ready to redeem their units so liquidity is not a problem for the investor.

Nonsystematic Risk

Risk Specific to a particular security. The best example is business risk; it is based upon management decisions, competition, or product deficiencies, and it is independent of the general market. This risk can be diversified away.

Political Risk

Risk of political upheavals, such as a coup or nationalization of an industry, will have a negative effect up an investment.

Legislative Risk

Risk that legal changes (think tax increases) can cause financial distress to corporate (and personal) earnings

Opportunity Cost

The 90-day Treasury bill is currently yielding 6^. An investor decides to purchase a stock with an expected return fo 11%. If that stock actually returns 2%, the opportunity cost is 4% (6%-2%)

Regulatory Risk

The risk that changes in regulations may negatively affect the operations of a company. (EPA)

Sovereign Risk

risk that a sovereign government will default to its obligations

Among the provisions of the Investment Company Act of 1940 designed to protect the interests of investors is the provision that A) any change in fundamental investment policy must be approved by stockholders B) for diversification purposes, an investment company may own up to 10% of the shares of another investment company C) selection of company investments must be approved by SEC D) communications with the public must be approved by FINRA before its use

A. One of the requirements of the Investment Company Act of 1940 is that an investment company cannot change its investment policy without approval of a majority vote of the shareholders. For example, the board of directors of a growth fund could not change the fund's investment objective to income without that approval. This has the effect of offering protection to the investors that they won't be "blindsided" by the board or the portfolio manager. On this exam, you shouldn't expect to see anything "approved" by the SEC as a correct answer. An investment company may own up to 3% of another investment company, not 10%. Even though FINRA rules do require approval of investment company communications with the public, such approval is not part of the Investment Company Act of 1940.

You have been following GEMCO stock for the past couple of months and notice a recent increase in the stock's volatility. In the past month, several negative reports have been published about GEMCO's product line. This has caused a drop in the market price of the stock even though the GEMCO has just reported earnings that exceeded analyst's projections. This is an example of A) financial risk B) market risk C) purchasing power risk D) volatility risk

B. Market risk is the uncertainty that a stock's price will move in a manner unrelated to the company's fundamentals. A prime example of this is when earnings go one way and the stock price the other. What we are not told in the question is the performance of the stock market. It is likely that the overall market has declined over this period (and that must be assumed here—poor test question writing). Financial risk is, as the name indicates, related to financing circumstances. This typically occurs when a company is overleveraged and may not be able to cover its debt service. Another financial risk is lack of cash flow, but nothing in this question indicates that situation.

From first to last, in what order would claimants receive payment in the event of bankruptcy? A) Subordinated debentures, preferred stockholders, general creditors, secured debt B) Preferred stockholders, secured debt, general creditors, subordinated debentures C) Secured debt, general creditors, subordinated debentures, preferred stockholders D) Secured debt, subordinated debentures, general creditors, preferred stockholders

C. The liquidation order is as follows: secured debt holders, unsecured debt holders (including general creditors), holders of subordinated debt, preferred stockholders, and common stockholders.

Among the advantages of being the holder of secured bond is that if the issuer files for bankruptcy, you A) will receive your principal plus all unpaid interest B) are paid ahead of everyone, except past-due wages to employees C) are sure to recover 100% of your investment D) are paid ahead of holders of unsecured debt, as well as equity securities

D. Secured bondholders are on the top of the list of creditors. The first priority for unsecured claims is that of employees and taxes.​ Even with a secured claim, there is no assurance that you will receive all your money back (think of the "short sales" on homes not long ago where the bank accepted less than the mortgage amount because the value of the home had fallen so far).

Which of the following securities are the most interest rate sensitive? I. Utility stocks II. Growth stocks III. Preferred stocks IV. Common stocks

I and II Utility and preferred stocks are the most interest rate sensitive. Utility stocks are interest rate sensitive because they are highly leveraged. Preferred stocks are interest rate sensitive because they have a set dividend and fluctuate in price like bonds when interest rates change.