Unit 12
Preferred Stock Pros
-Fixed income from dividends -Prior claim ahead of common stock -Convertible preferred sacrifices income in exchange for potential appreciation. Although it is generally regarded as a fixed-income investment, preferred stock, unlike debt securities, usually has no preset date at which it matures and no scheduled redemption date. Preferred stock is thus a perpetual security.
Preferred Stock Cons
-Market risk—in an economic downturn, fear of an inability to maintain the dividend will cause the price to drop -Possible loss of purchasing power -Interest rate (money rate) risk -Business difficulties leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal
Corporations have found that one way to increase employee motivation is to grant options to purchase stock in the company. Incentive (qualified) options differ from nonqualified options in all of the following respects except A) the recipient of the grant of the ISO has no income tax consequences at the time of the grant. B) there is a maximum 10-year limit for exercising an ISO; no such time limit exists for an NSO. C) the holder of an ISO can recognize capital gain (loss) as a result of exercise, whereas ordinary income (loss) is the result with an NSO. D) ISOs may only be granted to employees while NSOs may be given to virtually anyone.
A. Whether the grant is of an ISO (qualified) or an NSO (nonqualified), there are no tax consequences to the recipient at the time of the grant. It is only after exercise (NSO) and sale after exercise (ISO) that the recipient of the grant has tax consequences. Each of the other choices represents a difference. ISOs can only be granted to employees while the NSO can also be granted to members of the board of directors and even to vendors. With an ISO, capital gain (loss) treatment is available upon the sale of the stock if the recipient holds the stock purchased through exercise at least 1 year from the date of exercise and at least 2 years from the date of the grant. With an NSO, the recipient can only have ordinary income (loss) based on the difference between the exercise price and the market value when the option is exercised. Finally, if the recipient of an ISO does not exercise the option within 10 years of the grant, it is treated as an NSO for tax purposes.
During the analysis of XYZ stock, a technical analyst concludes that XYZ's support level has been broken. Being a technician, the most appropriate decision should be to A) purchase additional shares of the stock. B) rate the stock as a sell. C) rate the stock as a buy. D) rate the stock as a hold.
B. If a support level is broken, this provides a sell signal. Once the stock has lost its support, expectations are that it will continue to fall. The breaking of a resistance level, as the price of the asset gathers momentum to the upside, indicates a buying opportunity.
The residual right of common stockholders refers to their right to A) vote in elections for the board of directors and in other important business decisions, such as changes to the charter B) examine the corporation's annual reports and other reports, and take legal action if irregularities are found C) receive all announced dividends in accordance with the number of shares held D) claim company assets in bankruptcy after wages, taxes, creditors, and preferred shareholders have been paid
D. The residual right of common shareholders refers to their position in the event of bankruptcy.
Which of the following statements regarding a 100% stock dividend are TRUE? I. The share price is reduced by half. II. The total market value of the outstanding stock decreases. III. The total market value of the outstanding stock may increase or IV. decrease as a result of the split. The number of shares doubles.
I and IV In a 100% stock dividend, the number of outstanding shares is doubled and the price is reduced by half. The total market value (market cap) of the issuer's stock remains the same.
Restricted Securities
Retail investors cannot sell these securities until having held them for a certain period; they are restricted from immediate resale. Length of restriction is typically 6 months
Advance/Decline Theory
The number of issues closing up or down on a specific day reflects market breadth. The number of advances and declines can be a significant indication of the market's relative strength. When declines outnumber advances by a large amount, the market is bearish even if it closed higher. In bull markets, advances substantially outnumber declines. Technical analysts plot daily advances and declines on a graph to produce an advance/decline line that gives them an indication of market breadth trends.
Dividend Growth Model
This model assumes that the amount of the annual dividend will grow at a constant rate. Because projections of future growth can be hazy, this model is best used in conjunction with other forecasting tools.
Odd-Lot Theory
Typically, small investors engage in odd-lot trading, which is transactions of fewer than 100 shares. Odd-lot theorists believe that small investors invariably buy and sell at the wrong times. When odd-lot traders buy, odd-lot analysts are bearish. When odd-lot traders sell, odd-lot analysts are bullish.
Technical Analyst
charts a stock's price and volume over a period of time.
ADR/American Depositary Shares
negotiable security that represents a receipt for shares of stock in a non-U.S. corporation. issued by domestic branches of U.S. banks and that, even though they are traded in U.S. dollars, they still bear currency risk.
Short Interest Theory
refers to the number of shares that have been sold short. Because short positions must be repurchased eventually, some analysts believe that short interest reflects mandatory demand that creates a support level for stock prices. It seems counterintuitive, but high short interest is a bullish indicator, and low short interest is a bearish indicator.
Controlled Stock
stock held by a control person.What makes it control stock is who owns it, not how it was acquired. For purposes ofthis discussion, a control person is a corporate director, officer, large stockholder, or the immediate family of any of the preceding
Adjustable Rate Preferred
-Some preferred stocks are issued with adjustable (or variable) dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as quarterly. Because the payment adjusts to current interest rates, the price of the stock remains relatively stable. -For investors looking for fixed income through preferred stocks, adjustable-rate would be their least appropriate choice. -A preferred stock could be cumulative and callable, callable and convertible, or any combination of these adjectives. If none are listed, it is just a straight preferred.
Convertible Preferred Stock
-owner can exchange the shares for a fixed number of shares of common stock of the issuing corporation. -Because the value of a convertible preferred stock is linked to the value of common stock, the convertible's preferred price tends to fluctuate in line with the common.
One characteristic found in equity securities issued by a corporation is A) preemptive rights B) limited liability C) a history of keeping pace with inflation D) cumulative dividends
B. Equity securities include common and preferred stock. Both have the benefit of limited liability; the investor can never be held liable for debts of the corporation. Only common stock has preemptive rights and the potential for growth to keep pace with inflation. It is preferred stock that can have the cumulative feature regarding its dividends.
In a portfolio containing common stock, straight preferred stock, convertible preferred stock, and adjustable rate preferred stock, changes in interest rates would be most likely to affect the market price of the A) convertible preferred stock B) straight preferred stock C) common stock D) adjustable rate preferred stock
B. Fixed income securities, such as straight preferred stock, are the most sensitive to interest rates among the alternatives listed. Convertible preferred stock is influenced more by the common stock because it is convertible into the underlying security. Because the dividend rate on adjustable rate preferred stock is usually tied to changes in interest rates, the price of this stock remains stable in the face of rising or falling rates.
Callable Preferred
company can buy back from investors at a stated price after a specified date. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one when the cost of money has gone down. This is similar to refinancing a mortgage.
One of the features of convertible preferred stock is that A) the holder is able to select the conversion price B) the dividend is paid ahead of all other securities C) the owner has the opportunity to participate in the growth of the company D) the owner has the opportunity to convert the stock into the issuer's bonds
C. Any convertible security, preferred stock or debenture, is convertible into the issuer's common stock. As a result, if the business is successful, the common stock's price will rise to the point where conversion is a wise idea. Although the investor can generally select when to convert, the conversion price or ratio is set at the time of issuance. Interest on debt securities is paid before the dividends on any stock. When it comes to preferred stock, there is frequently a "pecking order", such as a prior lien preferred or first preference preferred that would come ahead of the other preferred shares.
A customer owns cumulative preferred stock (par value of $100) that pays an 8% dividend. The dividend has not been paid this year or for the 2 previous years. How much must the company pay the customer per share before it may pay dividends to the common stockholders? A) $0.00 B) $16.00 C) $24.00 D) $8.00
C. 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 due in back dividends, in addition to $8 this year, for a total of $24.
Investing in emerging market stocks is least likely to expose your client to which of the following risks? A) Political B) Currency C) Interest rate D) Liquidity
C. Interest rate risk applies primarily to fixed income securities. Stock, unless it specifies preferred stock, are not normally considered to have interest rate risk. However, any foreign investment incurs currency risk and, when dealing with emerging markets, there is a higher degree of liquidity and political risk than with developed economies.
A client is considering the purchase of American depositary receipts (ADRs). She is looking to further diversify her portfolio. Which of the following is not a feature of this type of investment vehicle? A) ADRs are denominated in and pay dividends in U.S. dollars. B) ADRs are traded on exchanges and the OTC markets. C) Information regarding the foreign company is easily attainable. D) They are not subject to exchange rate, or currency, risk.
D. Even though ADRs are denominated in U.S. dollars, they are subject to exchange rate, or currency, risk. In order to trade in the U.S. markets, information about the foreign company must be available to investors. ADRs representing the best known companies typically trade on the NYSE or the Nasdaq stock market while lesser companies trade OTC.
KAPCO common stock is listed on the New York Stock Exchange. If an executive vice president of the company buys 400 shares of the company's stock on the NYSE, she A) may sell immediately without restriction B) may sell under Rule 144 only after a 6-month holding period C) may not sell until she leaves the company D) may sell immediately subject to Rule 144 volume limitations
D. If purchased in the open market, such as on the NYSE, the transaction is not a private placement and the stock does not have a holding period restriction. The officer, however, is an affiliate and is therefore subject to the reporting and volume limitations under Rule 144.
One way in which incentive stock options (ISOs) differ from nonqualified stock options (NQSOs) is that A) there is a maximum 5-year limit for exercise on the ISO while the time limit on the NQSO is 10 years. B) the bargain element of the ISO is reported as wages on the tax returns of the employer and the employee. C) gains on an ISO are always short-term while those on an NQSO are long-term. D) the bargain element of the ISO is an AMT preference item.
D. The only true statement here is that the bargain element (the difference between the current market price at the time of exercise and the strike price) of the ISO (but not the NQSO) is one of the preference items for the alternative minimum tax. It is the bargain element of the NQSO which is reported as wages and it is possible, although difficult, to have long-term capital gains on both. Only the ISO has a maximum time limit and it is 10 years, not 5.
One of the rights of being a stockholder is the ability to vote on important corporate matters, such as the election of members to the board of directors. The date that determines which shareholders are eligible to votes is A) the ex-dividend date. B) the last day of the company's fiscal year. C) the election date. D) the record date.
D. The record date is a date announced by the company as the official date you must be an owner on the company's records in order to participate in the annual meeting and corporate election. A fact not tested is there is no standard regarding how far in advance of the voting date this should be other than it must be at least the normal settlement period, currently 2 business days.
Which of the following statements regarding nonqualified stock options (NSOs) is CORRECT? A) Unlike ISOs, NSOs are publicly traded. B) The exercise of NSOs does not create taxable income. C) The NSO is taxable to the recipient at the time of grant to the extent of the difference between the fair market value of the stock and the grant price. D) The NSO is taxable to the recipient at the time of exercise to the extent of the difference between the fair market value of the stock and the exercise price.
D. The so-called "bargain element" of an NSO is taxed to the recipient as salary income at the time the option is exercised. Neither of the employee stock options is publicly traded.
Which of the following is used in technical analysis in an attempt to modify fluctuations of stock prices over the long term into a smoothed trend? A) Trend lines B) Support and resistance C) Consolidation D) Moving averages
D. To avoid the volatility frequently present in stock price trends, analysts will frequently use moving averages. These averages reduce short-term distortions to a minimum
If a customer owns 7% of a publicly-traded company's stock and his spouse owns 6% and wants to sell her shares, which of the following statements is true? A) The spouse is not an affiliate and Rule 144 applies. B) The spouse is not an affiliate and Rule 144 does not apply. C) The spouse is an affiliate and Rule 144 does not apply. D) The spouse is an affiliate and Rule 144 applies.
D. Together, the client and wife own 13% of the company's stock, so the spouse is considered an affiliate and is bound by Rule 144. If there is a 10% or more ownership interest among members of an immediate family living at the same residence, then all members are considered control persons (affiliates) subject to Rule 144. For exam purposes, assume that spouses share the same residence.
Which of the following are regulated under the Securities Exchange Act of 1934? I. Broker-dealers II. Investment advisers III. Pension plans IV. Transfer agents
I and IV The Securities Exchange Act of 1934 regulates broker-dealers and transfer agents. Investment advisers are regulated under the Investment Advisers Act of 1940 (and, to a certain extent, the Investment Company Act of 1940), whereas pension plans in the private sector are regulated under ERISA.
nonqualified stock options
These are the more common of the two varieties of employee stock options. Unlike the ISO, which is limited to employees only, NSOs can also be offered to board members and even suppliers. NSOs are basically treated as a form of compensation. When NSOs are exercised, the difference between the current market price, (or fair market value for stock that isn't actively traded), at the time of exercise and the strike price, referred to as the bargain element, is reported as wages on the tax returns of the employer and the employee. Therefore, instead of capital gains treatment, the employee is taxed as ordinary income while the company receives a tax deduction as salary expense for the difference between the current market price and the strike price. Subject to payroll and income taxes
Dividend Discount Model
This model states that the current market value of a stock should be equal to the present value of all future dividends.
Is ownership of more than 10% of the voting stock considered control? True or False
True All sales of control stock must be accompanied by a Rule 144 filing on Form 144
Incentive Stock Options (ISOs)
You might see these called qualified as a way of distinguishing them from NSOs. Unlikethe NSO, there are generally no tax consequences to the employer with an ISO, but, ifdone properly, they can be more advantageous than NSOs to the employee. As mentioned, the employee's profits from NSOs are taxed as ordinary income. However, as long as stock purchased through exercise of an ISO is held at least two years after the date of grant and one year after the date of exercise, any profits are reported as long-term capital gains. If these time limits are broached, the ISO is taxed like an NSO. There is one other time stipulation—there is a maximum 10-year limit for exercise.
Cumulative Preferred Stock
accrues payments due its shareholders in the event dividends are reduced or suspended.
