Unit 4: Questions

A corporation coming out of a bankruptcy proceeding would probably find it most attractive to issue A) a promissory note. B) a collateral trust certificate. C) a subordinated debenture. D) an income bond.

D Income (or adjustment) bonds carry the unique characteristic of requiring payment of interest only when the issuer's income is sufficient. They are used primarily for companies undergoing a financial restructuring, usually after a bankruptcy filing. Each of the other choices would require timely payment, and failure to do so could result in the company's failure. LO 4.a

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) IV, I, II, III B) III, I, II, IV C) I, II, III, IV D) I, III, II, IV

D 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

Regarding convertible debentures, one characteristic of which your clients should be aware of is that A) the conversion feature protects against an early call. B) they generally pay a higher interest rate than nonconvertible debentures. C) it is generally best to convert when the common stock is selling below its parity price. D) they trade in line with the issuer's common stock once the conversion price is reached.

D The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock. LO 4.c

A DMF convertible bond (convertible into 25 shares) has increased 20% above par in market value. Which of the following would you expect the price of the DMF's common stock to be? A) $42 B) $40 C) $32 D) $48

D The math is as follows: $1,000 (par) + 20% = $1,200 ÷ 25 shares = $48. Alternatively, it is ordinarily the 20% increase in the value of the common stock that has caused the bond to increase 20% in value: $1,000 ÷ 25 shares = $40 + 20% = $48. LO 4.d

An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $740. For tax purposes, this would result in A) a capital gain of $20. B) a capital loss of $20. C) a capital loss of $280. D) a capital gain of $100.

The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $740 is $20 more than the basis, the investor has a long-term capital gain. LO 4.e

The STU Corporation has issued common stock, preferred stock, promissory notes, and mortgage bonds. Should STU enter bankruptcy proceedings, the order of payment against claims would be A) the mortgage bonds, the promissory notes, the preferred stock, and the common stock. B) the promissory notes, the mortgage bonds, the preferred stock, and the common stock. C) the mortgage bonds, the preferred stock, the common stock, and the promissory notes. D) the preferred stock, the common stock, the mortgage bonds, and the promissory notes.

A In a bankruptcy, secured creditors, such as those with a mortgage against real property, have the first priority. They are followed by unsecured creditors, such as holders of promissory notes, with stockholders coming last. Preferred stock is preferred over common stock in both liquidation priority and payment of dividends. LO 4.b

Which of the following statements regarding corporate zero coupon bonds are true? I. Interest is paid semiannually. II. The discount is in lieu of periodic interest payments. III. The discount must be accreted and is taxed annually. IV. The discount must be accreted annually with taxation deferred until maturity. A) II and III B) II and IV C) I and IV D) I and III

A The investor in a corporate zero coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually, and the investor pays taxes yearly on the imputed interest. LO 4.a

An investor needing current income should not receive a recommendation to purchase A) zero-coupon bonds. B) convertible bonds. C) callable bonds. D) income (adjustment) bonds.

A Yes, income bonds only pay interest if the company earns enough to pay it. And, yes, convertible bonds pay less interest than nonconvertible bonds. And the callable bond can be called away when interest rates fall. Nevertheless, the investor does expect some income. When it comes to the zero-coupon bond, there is absolutely no current interest paid, so that would be the least likely recommendation here. LO 4.a

All the following statements concerning zero-coupon bonds are true except A) zero-coupon bond prices are more stable than other types of bonds. B) zero coupon bonds are most often issued with long-term maturities. C) zero-coupon bonds may be issued by the U.S. Treasury, corporations, and state and local governments. D) zero-coupon bonds pay no interest during the life of the bond.

A Zero-coupon bonds pay no interest during the life of the bond. Rather, investors purchase zeros at a deep discount from par. The difference between the discounted price and the maturity value is the interest the investor receives from the bond. In other words, zeros pay no interest until maturity. The effect of this is that their prices fluctuate more than other types of bonds when traded on the secondary market. Investors typically pay income tax on the phantom interest as it accrues each year. LO 4.e

Which of the following quotes would not be considered a corporate bond quote? A) A bond is quoted at 103 8s maturing in 2034. B) A bond is quoted at 104 3/32 maturing in 2037. C) A bond is quoted at 96 ¾ maturing in 2029. D) A bond is quoted at 103.16 zr maturing in 2040.

B Corporate bonds can be quoted in decimals or fractions. However, both corporate and municipal bonds would use fractions based upon eighths. Direct debt of the U.S. government can also use fractions. The difference is that U.S. government debt is based upon 32nds. Also note that when you see what looks like a decimal notation in U.S. government debt, it is actually based upon 32nds as well. LO 4.d

Under what circumstances will a dilution of equity occur? A) Stock split B) Conversion of convertible bonds into common stocks C) Stock dividend D) Issue of mortgage bonds to replace debentures

B Dilution of equity occurs when stockholders experience a reduction in their percentage ownership of the company. If bonds are converted, more common shares are issued, and the shareholder's equity is diluted. A stock dividend or stock split does not change a stockholder's percentage of ownership. Refunding debts has no effect on stockholders. LO 4.c

The GHI Transportation Company has run into decreased sales and is forced into a bankruptcy liquidation. Which of the following would have the most junior claim? A) Holders of GHI's equipment trust certificates B) Holders of GHI commercial paper C) Holders of GHI's collateral trust certificates D) Holders of GHI's mortgage bonds

B Secured debt (such as the mortgage bond), the collateral trust certificate, and the equipment trust certificate have first priority in the event of a bankruptcy. Commercial paper is a promissory note relying on the creditworthiness of the issuer. LO 4.b

An investor whose primary objective is a steady income flow would probably be best served by building a portfolio of A) cumulative common stock. B) investment-grade debentures. C) preferred stock. D) income bonds.

B The trick here is to remember that income bonds are issued during a corporate reorganization and only pay interest when and if the company has sufficient earnings. When a bond or debenture is investment grade, the likelihood of receiving timely interest payment is high. Preferred stock is generally a good source of income, but, because the dividends are not an obligation in the way that interest is, the stability of the income is less assured. There is no such thing as cumulative common stock, only preferred. LO 4.a

ABC Corporation has outstanding a 7.75% convertible debenture currently trading at 102. The bond is convertible into common stock at $40. ABC stock is trading $45 per share. Which of the following statements is true? A) The bond is at parity with the stock. B) To profit in this situation, the investor should buy the bonds and short the stock. C) An arbitrage opportunity does not exist in this situation. D) To profit in this situation, the investor should buy the stock and short the bonds.

B With a conversion price of $40, the bond is convertible into 25 shares of ABC common stock ($1,000 ÷ $40 = 25 shares). As the common stock is currently trading at $45 per share, the value of the stock as converted would be $1,125 (25 shares × $45 = $1,125), which is greater than the current price of the bond ($1,020). Therefore, the bond and the stock are not at parity. An investor could profit in this situation by shorting the stock and buying an equivalent number of bonds. A bond could be purchased for $1,020 and immediately converted into stock worth $1,125, a risk-free profit opportunity. LO 4.d

DMF Company has $50 million of convertible bonds (convertible at $50) outstanding. The current market value of DMF's stock is $42. The bond indenture contains a nondilution feature. If DMF declares a 10% stock dividend, the new conversion price will be A) higher than $50. B) lower than $50. C) $50. D) the stock's current market price.

B With an antidilution feature, the issuer will increase the number of shares available upon conversion if the company declares a stock split or stock dividend. This means the bondholder must be able to convert it to more shares, which requires a lower conversion price. LO 4.d

If a mutual fund's objective is income, it would not hold which of the following securities in its portfolio? A) Income bonds B) U.S. T-notes C) Preferred stock D) Corporate bonds

A A fund designed to generate current income for its shareholders would not hold an income bond, also known as an adjustment bond. Income bonds pay interest only if the issuer has enough earnings to do so. They are often issued by companies coming out of bankruptcy. As a result, these bonds tend to trade like zeroes. LO 4.a

Which of the following debt securities would be most likely to offer a conversion feature into common stock? A) A debenture B) Commercial paper C) Preferred stock D) A mortgage bond

A Invariably, when it comes to convertible debt securities, they are debentures rather than secured bonds. The conversion concept makes no sense with money market securities—they mature in one year or less. Preferred stock is often convertible, but it is an equity security, not a debt security. LO 4.c

With a bearish outlook on the market, an investor would like to purchase something that will generate income now during current bearish conditions but would also be able to take advantage of capital appreciation should market sentiment turn bullish. Which of the following would be a suitable purchase recommendation that puts the investor in a position to do both? A) Nonconvertible bonds B) Convertible bonds C) Cumulative preferred stocks D) Common stock

B A convertible bond would generate income from interest payments during the bear market, but if market sentiment becomes bullish, the bond can be converted into common stock, taking advantage of the change in market conditions. None of the remaining choices could fulfill both of these investment objectives. LO 4.c

The market price of a convertible bond depends on all of the following except A) the rating of the bond. B) the value of the underlying stock into which the bond can be converted. C) current interest rates. D) the conversion prices of bonds from similar companies.

D A convertible bond's current market price will be impacted by the value of the underlying stock into which the bond can be converted, current interest rates, and the rating of the bond. Conversion prices are not set in competition; therefore, the conversion prices of similar bonds would be of no concern regarding price. LO 4.d

Which of the following is not a type of corporate debt instrument? A) Revenue bond B) Mortgage bond C) Income bond D) Subordinated debenture

A A revenue bond is a type of municipal bond. Income bonds are usually issued by companies coming out of a bankruptcy where the company is obligated to pay the semiannual interest only if there are sufficient earnings. Mortgage bonds are secured by real property, such as the company's physical facilities, and subordinated debentures are unsecured debt and come last in line among the creditors. How were you supposed to know what revenue bonds are? You might have a question where the correct response is something you never heard of. What do you do? Eliminating the choices you know are incorrect is an important test-taking technique. Look at this question. The other three choices are covered under the topic of corporate debt issues; that should have made the correct answer obvious. LO 4.a

Your recently retired client is looking to diversify a largely growth-oriented portfolio to create income to replace salary. Which of following would be the least suitable security to place into the portfolio? A) AAA-rated zero-coupon corporate bonds B) AA-rated preferred stock C) A-rated mortgage bonds D) AA-rated public utility common stock

A Although the zero-coupon bonds have the highest rating of all, they are unsuitable for this investor because they provide no income; that is what the zero coupon means. Bonds, especially those with an A rating, will provide steady income, as will high-quality preferred stock and public utility common stock. LO 4.a

An investor interested in acquiring a convertible bond as part of her investment portfolio would A) want the safety of a fixed-income investment along with potential capital appreciation. B) be interested in tax advantages available to convertible debt securities. C) seek to minimize changes in the bond price during periods of steady interest rates. D) want the assurance of a guaranteed dividend on the underlying common stock.

A 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

All of the following statements regarding convertible bonds are true except A) holders receive a higher interest rate. B) holders may share in the growth of the common stock. C) the issuer pays a lower interest rate. D) holders receive a fixed interest rate.

A Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. The interest rate on a convertible, just as with any other fixed-income security, does not change. LO 4.c

Which of the following corporate bonds is backed by other securities? A) Collateral trust bond B) Mortgage bond C) Debenture D) Equipment trust certificate

A Collateral trust bonds are backed by a portfolio of other securities, while mortgage bonds are backed by real estate. Equipment trust certificates are backed by equipment, while debentures are backed only by the company's promise to pay. LO 4.a

Which of the following debt instruments is unsecured? A) AAA/AAA-rated debentures B) Junior lien mortgage bonds C) Collateral trust certificates D) Equipment trust certificates

A Corporate debentures are unsecured bonds backed by the credit of the issuing corporation; they are not secured by underlying collateral. Mortgage bonds are secured with real estate serving as collateral. Collateral trust bonds are secured by securities that a corporation owns in other companies or bonds. Equipment trust certificates are secured by transportation equipment owned by the corporation. LO 4.a

Under what circumstances will a dilution of equity occur? A) Conversion of convertible bonds into common stocks B) Issue of mortgage bonds to replace debentures C) Stock split D) Stock dividend

A Dilution of equity occurs when stockholders experience a reduction in their percentage ownership of the company. If bonds are converted, more common shares are issued, and the shareholder's equity is diluted. A stock dividend or stock split does not change a stockholder's percentage of ownership. Refunding debts has no effect on stockholders. LO 4.c

If ABC Corporation reports a loss for the year, it is obligated to pay interest on all of the following debt securities except A) income bonds. B) convertible bonds. C) debentures. D) cumulative preferred stock.

A 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

You have a client who is about to retire and wants to rearrange his portfolio to have predictable income. Which of the following would not be a good investment vehicle? A) Income bonds B) AA-rated debenture C) AA-rated IDB D) U.S. Treasury note

A Income bonds, also known as adjustment bonds, are issued when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the company has enough income to meet the interest payment. As a result, these bonds normally trade flat without accrued interest. Therefore, they are not suitable for customers seeking income. LO 4.a

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 money after the secured creditors but before the holders of standard debentures. C) receive his loaned money first over any other investor because he is a founder of the company. 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 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

A corporation with an outstanding convertible debenture issue could force conversion by A) publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price. B) decreasing the coupon rate on the debenture to a level where the dividend on the common stock provides a higher return. C) soliciting proxies from the common shareholders asking them to vote for mandatory conversion. D) issuing new debentures with a higher coupon rate.

A Most convertible debt securities are callable, usually at a price slightly above the par value. When the price of the underlying common stock rises to a point where the converted value of the bond is worth more than the par value, issuers will frequently exercise their call privilege. Because the call price is usually significantly less than the converted value, it is only common sense that the debenture holders will exercise their conversion privilege. 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 time $25 per share). 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 on to 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. Shareholders do note vote on a management decision to call in debt. The coupon rate on the debenture is fixed; the issuer doesn't have the ability to change it. LO 4.c

Phantom income is a characteristic of A) zero-coupon bonds. B) convertible bonds. C) American depositary receipts. D) preferred stock.

A Phantom income is the term used to describe income that is not received but is taxed. With zero-coupon bonds, the principal payoff at maturity represents receipt of the discount in lieu of periodic interest. However, each year, a portion of that discount is reported to the IRS on Form 1099 OID and is taxed as ordinary income unless the security is a municipal bond. LO 4.e

What is the order of liquidation in the event of a corporate bankruptcy? A) Senior bonds, general creditors, preferred stock, common stock B) Common stock, preferred stock, general creditors, senior notes C) Senior bonds, preferred stock, subordinated debt, common stock D) General creditors, senior notes, preferred stock, common stock

A Senior bonds are those with collateral pledged to protect the investors. They always come first. They are followed by general creditors with the last of those being holders of subordinated debt. Last in line are the equity holders. That would be preferred stock and common stock at the end. LO 4.b

If LMN, Inc., has filed for bankruptcy, in what order would interested parties be paid? I. Holders of secured debt II. Holders of subordinated debentures III. General creditors IV. Preferred stockholders A) I, III, II, IV. B) I, II, III, IV. C) III, I, II, IV. D) IV, I, II, III.

A The liquidation order is as follows: the IRS (and other government agencies), secured debt holders, unsecured debt holders and general creditors, holders of subordinated debt, preferred stockholders, and common stockholders. LO 4.b

ABC Corporation has issued a convertible preferred stock with a par value of $100. The stock is convertible at $40. The current market price of the preferred stock is $80. It would be correct to state that the conversion ratio is A) 2.5:1. B) 4:10. C) 4:5. D) 2:1.

A When a $100 par preferred has a conversion price of $40, the stockholder can convert into 2.5 shares. That is a 2.5:1 ratio. The current market price of the stock is only relevant if the question asks about the parity price (which is $32). As a refresher, the parity price is that market price where the value of the shares received on conversion is equal to (at parity with) the market price of the convertible security. With the preferred stock selling at $80 per share and being convertible into 2.5 common shares, when the market price of the common is $32 ($80 ÷ 2.5) we have parity because 2.5 times $32 = $80. LO 4.d

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) $945 B) $1,045 C) $1,000 D) $900

A 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

An investor owns a convertible debenture with a conversion price of $10. If a 10% stock dividend is paid on the company's common stock, which of the following is true? A) The conversion price will be adjusted to $9.09. B) The conversion price will be adjusted to $11.00. C) The investor will receive 1 share of the common stock. D) The investor will receive 10 shares of the common stock.

A You can assume that any convertible security on the exam will have an anti-dilutive provision. That means that a stock dividend or stock split will not cause the investor's conversion privilege to be diminished. With a conversion price of $10, the investor was able to convert into 100 shares ($1,000 divided by $10). After the 10% stock dividend, the investor must be able to convert into 10% more shares (110 shares). To get 110 shares from a $1,000 principal, the price must be reduced. The computation is $1,000 divided by 110. That equals $9.09 per share. LO 4.c

An investor owns a convertible debenture with a conversion price of $10. If a 10% stock dividend is paid on the company's common stock, which of the following is true? A) The conversion price will be adjusted to $9.09. B) The investor will receive 10 shares of the common stock. C) The investor will receive 1 share of the common stock. D) The conversion price will be adjusted to $11.00.

A You can assume that any convertible security on the exam will have an anti-dilutive provision. That means that a stock dividend or stock split will not cause the investor's conversion privilege to be diminished. With a conversion price of $10, the investor was able to convert into 100 shares ($1,000 divided by $10). After the 10% stock dividend, the investor must be able to convert into 10% more shares (110 shares). To get 110 shares from a $1,000 principal, the price must be reduced. The computation is $1,000 divided by 110. That equals $9.09 per share. LO 4.c

An investor interested in acquiring a convertible bond as part of her investment portfolio would A) seek to minimize changes in the bond price during periods of steady interest rates. B) want the safety of a fixed-income investment along with potential capital appreciation. C) be interested in tax advantages available to convertible debt securities. D) want the assurance of a guaranteed dividend on the underlying common stock.

B 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

All of the following statements regarding convertible bonds are true except A) holders may share in the growth of the common stock. B) holders receive a higher interest rate. C) holders receive a fixed interest rate. D) the issuer pays a lower interest rate.

B Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. The interest rate on a convertible, just as with any other fixed-income security, does not change. LO 4.c

One of your customers owns 10 HBH Creations 4.5% convertible callable debentures. The conversion price into HBH common stock is $40. With the current market price of the HBH Creations stock at $44, the company publishes a notice that all of the debentures will be called in thirty days at a price of 104. When the customer calls for your advice, you would probably recommend A) accepting the call. B) exercising the conversion privilege. C) selling the stock. D) selling the debenture.

B Generally, a corporation exercises the call privilege when the call price is below the parity price. With a current market price of the stock at $44 per share, the parity price of the debenture is 110 ($1,100). The effect of this call is that it, in essence, forces the investors to convert, and the issuer never has to pay off the debt. Let's take a look at the math here. With a conversion price of $40, a debt security with a par value of $1,000 is convertible into 25 shares ($1,000 ÷ 40). If the stock is currently selling at $44 per share and the investor could convert into 25 shares, it makes the conversion worth $1,100 (25 shares × $44 = $1,100). In our question, the call price is 104 ($1,040) so the question becomes, "What is a better deal for your customer: exercising the conversion privilege that gives the customer stock with a value of $1,100 or accepting the call worth $1,040?" Why not just sell the debentures? Because once the call at 104 has been issued, the price of the debentures will decline to approximately that level. Why not sell the stock? The investor doesn't own any stock until conversion, so there is nothing yet to sell. LO 4.c

Convertible debentures offer which of the following benefits to investors? A) A higher coupon rate than comparable non-convertible debt B) The upside potential of a common stockholder with less downside risk C) Forced conversion when the underlying stock price increases D) Highest priority in the event of dissolution

B If the price of the underlying stock increases, the holder of the debenture can exercise the conversion privilege and capture that growth. Unlike the stock, as a debt security, the regular periodic interest payments tend to provide a floor below which the price of the debenture will not fall. In exchange for this benefit, the coupon rate is lower than a comparable non-convertible security. Many of these convertibles have a call feature. If the price of the stock rises, the issuer may decide to call it in and the investor's best option is to convert. This is known as forced conversion and forces the investor in a debt security to own an equity security. Debentures have a lower priority in dissolution than secured bonds. LO 4.c

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) Reduce the coupon rate below the dividend rate on the common stock D) Exercise the conversion feature when the debt security's conversion value exceeds the call price

B 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

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 will be called. B) The bond is selling at a premium. C) The bond is selling at a discount. D) The coupon will be adjusted.

B 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

ABC Company issues a 10% bond due in 10 years. The bond is convertible into ABC common stock at a conversion price of $25 per share. The ABC bond is quoted at 90. Parity of the common stock is A) $100.00. B) $22.50. C) $36.00. D) $25.00.

B The bond is quoted at 90, so it is selling for $900. The parity price of the common stock is $22.50, calculated as follows: the bondholder could convert the bond into 40 shares of stock ($1,000 face amount ÷ $25 per share = 40 shares). Because the bond has a current price of $900, divide $900 by 40 to get the underlying parity price (90% × $25 = $22.50). LO 4.d

A customer purchased an ABC $3 convertible preferred stock at $60. The par value is $50 and the conversion price is $5. If the common stock is trading a half point below parity, the price of ABC common is A) $4.50. B) $5.50. C) $9.50. D) $2.50.

B The conversion ratio is computed by dividing par value by the conversion price ($50 par ÷ $5 = 10). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($60 ÷ 10 = $6). $6 − 0.50 = $5.50. LO 4.d

A commonly used investment to provide a defined sum in the future, such as for college education or retirement, is A) convertible bonds. B) zero-coupon bonds. C) warrants. D) common stock.

B The key to this question is the defined sum. Zero-coupon bonds are usually purchased at a deep discount, which helps a small initial deposit grow into a substantial sum at maturity. Common stocks can't promise a specific sum when it is time for college. Warrants simply give the holder an opportunity to purchase the specified stock in the future; they have no defined value. Although convertible bonds with a maturity at the target date will provide the defined sum, the internal compounding of the zero-coupon bond will generally provide a higher return. LO 4.a

A couple with a child who is six years away from entering college has saved $150,000 for that child's college tuition. Which of the following portfolio mixes would be the most suitable for meeting the investment objective? A) 85% corporate bonds, 15% Treasury STRIPS B) 70% Treasury STRIPS, 20% equities, 10% cash equivalents C) 20% T-bills, 10% corporate bonds, 70% equities and equity funds D) 30% investment grade corporate bonds, 70% equities

B Treasury STRIPS—zero-coupon bonds that are purchased at a discount and mature at face value—are a suitable investment for future, anticipated expenses such as college tuition when there is a relatively short time horizon. The equities are included to provide some inflation protection. The cash equivalents (money market instruments) add stability. The two choices with 70% equities are taking too much market risk, and the choice with only debt securities is subject to inflation risk. LO 4.a

An investor purchases a bond on its initial public offering. Even though the bond has a maturity value of $1,000 in 10 years, the offering price is only $600. If this investor holds the bond until it matures, A) there is a $360 long-term capital gain and $40 in ordinary income. B) there is a $400 long-term capital gain. C) there is no reported capital gain. D) $400 is reported as ordinary income.

C A bond issued at a significant discount from its maturity value is known as an original issue discount bond (OID). In the case of a corporate bond, the computation is more complex than can be tested, but there are two things you need to know: A portion of the discount is taxed as ordinary income each year until maturity, even though it is not actually received. This is called phantom income. Each year's taxable amount is reported on Form 1099-OID. Because a portion of the discount has been taxed each year, at maturity all $400 of the discount has been accreted. This results in no reported capital gain LO 4.e

A grocery chain owns many regional supermarkets. The chain experiencing economic hardship, and gets its debt downgraded by S&P. The chain needs to raise capital. What would be the best for raising capital? A) The regional chain should issue preferred stock to the investors letting them know that preferred shareholders have a preference in liquidation above general creditors. B) 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. C) 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. D) 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.

C 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

KLM Company has 10 million convertible bonds outstanding that are convertible at $25. The bonds contain an antidilution feature. If KLM declares a 10% stock dividend, the new conversion price will be A) $50.00. B) $22.50. C) $22.73. D) $45.45.

C Before the stock dividend, an investor would have received 40 shares of stock for each $1,000 bond ($1,000 ÷ $25). A 10% stock dividend would now give an investor 44 shares on conversion (40 shares + 10% = 4 shares more). $1,000 ÷ 44 shares = $22.73 per share for the new conversion price. LO 4.d

ABC Company issued $20 million of convertible bonds with a coupon of 5% and a current market value of 120. The conversion price is $40. If all the bonds are converted, how many additional shares of common stock will ABC have outstanding? A) 400,000 B) 600,000 C) 500,000 D) 1,000,000

C Each bond will convert to 25 shares of common stock ($1,000 ÷ $40). The company issued 20,000 bonds ($20,000,000 ÷ $1,000). Therefore, 500,000 additional shares (20,000 × 25) will be outstanding if all the bonds are converted. LO 4.c

Which of the following would be the most likely unsuitable recommendation for a client whose objective is steady income? A) A bank CD B) A subordinated debenture C) An income bond D) A U.S. Treasury bond

C Income (or adjustment) bonds carry the unique characteristic of requiring payment of interest only when the issuer's income is sufficient. They are used primarily for companies undergoing a financial restructuring, usually after a bankruptcy filing. Don't be fooled by the subordinated debenture. Although it stands last in line of the creditors in the event of a liquidation, that does not mean the investor is not going to get regular interest payments, especially when the debenture is investment grade. Bank CDs typically pay interest quarterly. LO 4.a

OH is a general merchandiser that has existed for more than 100 years. It was unable to keep up with modern times and has not been profitable for many years, which led to the company defaulting on their debt. The company negotiated to restructure their debt as an income bond to relieve them of paying interest until the company can become profitable again. Bondholders of the income bond would A) receive all past interest payments that were not paid while the company struggled to return to profitability. B) finally receive interest income only when the company is profitable and has net income that can meet the interest payments. C) receive interest payments when the board of directors declares a payment after the company has income that can meet the interest payment. D) be guaranteed that the company will pay back the entire principal at maturity but not the missed interest payments while they were not profitable.

C Income bonds are bonds received after the company has suffered severe financial reverses so that they need to restructure the debt. To prevent the company from failing, the creditors will not receive interest on the debt while the company is not profitable. Hopefully the company will return to profitability. When it does have enough income to pay the interest, it will start paying interest, but first the board of directors must declare that it will pay. Profitability alone does not determine that the company will pay the interest. Additionally, all the past missed payments will not be paid back because these bonds trade flat, without the accrued interest payments. Furthermore, there is no guarantee the company will ever survive to pay back the principal. LO 4.a

What action could a corporation take that would result in the forced conversion of an outstanding convertible debt security? A) Exercise the conversion feature when the debt security's conversion value exceeds the call price B) Reduce the coupon rate below the dividend rate on the common stock C) Exercise the call feature when the debt security's conversion value exceeds the call price D) Reduce the dividends on the common stock to a rate lower than the interest on the debt security

C 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

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 $60. B) The conversion ratio is 22:1 with parity price of the common stock at $55. C) The conversion ratio is 20:1 with parity price of the common stock at $55. D) The conversion ratio is 22:1 with parity price of the common stock at $60.

C 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

An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $700. For tax purposes, this would result in A) a capital gain of $20. B) a capital loss of $280. C) a capital loss of $20. D) a capital gain of $100.

C The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $700 is $20 less than the basis, the investor has a long-term capital loss. LO 4.e

An investor seeking income combined with a conservative level of risk would purchase A) AAA-rated convertible debentures. B) junk bonds. C) AA-rated mortgage bonds. D) unrated income bonds.

C The conservative level of risk eliminates the income bonds and the junk bonds. Income bonds pay interest only if the issuer has the funds to do so. Junk bonds are named such because of their high risk. Even though the convertible debentures have a higher rating than the mortgage bonds, the difference is relatively insignificant at that level and either would be suitable for the conservative investor. However, because of the convertible feature, it is always true on the exam that the income return is lower than non-convertible issues. Therefore, the most suitable for this investor would be the mortgage bonds. LO 4.a

A customer purchases an ABC $100 par 6½% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading 2 points below parity, the price of ABC common is A) $12. B) $16. C) $14. D) $18.

C The conversion ratio is computed by dividing par value by the conversion price ($100 par ÷ $20 = 5). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($80 ÷ 5 = $16). $16 − 2 = $14. LO 4.d

Which of the following statements regarding corporate zero coupon bonds are true? I. Interest is paid semiannually. II. The discount is in lieu of periodic interest payments. III. The discount must be accreted and is taxed annually. IV. The discount must be accreted annually with taxation deferred until maturity. A) II and IV B) I and III C) II and III D) I and IV

C The investor in a corporate zero coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually, and the investor pays taxes yearly on the imputed interest. LO 4.a

A DMF convertible bond (convertible into 25 shares) has increased 20% above par in market value. Which of the following would you expect the price of the DMF's common stock to be? A) $42 B) $32 C) $48 D) $40

C The math is as follows: $1,000 (par) + 20% = $1,200 ÷ 25 shares = $48. Alternatively, it is ordinarily the 20% increase in the value of the common stock that has caused the bond to increase 20% in value: $1,000 ÷ 25 shares = $40 + 20% = $48. LO 4.d

A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What is the parity price of the debenture? A) $910 B) $850 C) $920 D) $929

C To determine the parity price of the bond, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 ÷ $25 = 40 shares). Next, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920). LO 4.d

When analyzing a convertible debt security, it is most likely the issue is A) a bond. B) a convertible preferred stock. C) a debenture. D) a zero-coupon security.

C 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

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) Corporate preferred shares B) Corporate debt securities C) Zero-coupon bonds D) Ginnie Mae government securities

C 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 owns 100 shares of the 4% $80 par convertible, callable, cumulative preferred stock issued by HBH Creations. With a conversion price of $20 and a current market price of $84, HBH issues a call of all of the outstanding preferred shares at $82. If the HBH Creations common stock is currently selling at $18 per share, what is likely the wisest choice for the investor? A) Convert the preferred into the common at the stated conversion rate B) Hold on to the preferred stock C) Sell the preferred stock D) Accept the call at $82

D Although issuers generally exercise the call privilege when the common stock's price is above the conversion price, there are cases when the call is exercised with the hope of eliminating some of the preferred shares with their preferred dividend payout. Let's go through the math of this question. With a par value of $80 and a conversion price of $20, each share of the preferred stock is convertible into 4 shares of the HBH Creations common stock. If the investor converts, those 4 shares are worth $18 each or a total of $72 for each share of preferred converted. That being the case, the investor's decision is to convert and have stock worth $7,200 (remember, there are 100 shares of the preferred, each convertible into 4 shares of the common) or call at $82 per share of preferred totaling $8,200. Why not sell the preferred stock at $84? Because the moment the call is announced, the price of the preferred will fall. Holding on to the preferred stock doesn't make sense because after the call date, the preferred will no longer receive dividends. LO 4.c

An investor purchased a PQR convertible bond at 98 on June 18, 2023. The bond is convertible at $25 (40:1) on January 1, 2024. On June 20, 2024, when the common stock is trading at around $26 per share, the investor converted the bond into the company's common shares. For tax purposes, these transactions would most likely result in A) approximately a $40 capital loss. B) approximately a $60 capital gain. C) approximately a $40 capital gain. D) neither gain nor loss.

D Converting a convertible bond into common stock is not a taxable event. When the stock is sold, the taxable event occurs. LO 4.c

Which of the following debt instruments is unsecured? A) Collateral trust certificates B) Equipment trust certificates C) Junior lien mortgage bonds D) AAA/AAA-rated debentures

D Corporate debentures are unsecured bonds backed by the credit of the issuing corporation; they are not secured by underlying collateral. Mortgage bonds are secured with real estate serving as collateral. Collateral trust bonds are secured by securities that a corporation owns in other companies or bonds. Equipment trust certificates are secured by transportation equipment owned by the corporation. LO 4.a

Which of the following statements regarding convertible bonds is not true? A) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature. B) Convertible bondholders are creditors of the corporation. C) Coupon rates are usually lower than nonconvertible bond rates of the same issuer. D) Coupon rates are usually higher than nonconvertible bond rates of the same issuer.

D Coupon rates are not higher; they are lower because of the value of the conversion feature. The bondholders are creditors. If the stock price falls, the conversion feature will not influence the bond's price. LO 4.c

Which the following statements concerning taxes on corporate bonds is true? A) Bonds held to maturity can only have long-term capital gains. B) Short term capital gains on bonds derive from the interest income because the interest is always paid out twice in a year. C) Bonds are always considered long term so it is impossible to have short term capital gains when purchasing bonds. D) Interest income from a corporate bond is taxed based upon ordinary income rates only.

D Interest income from corporate bonds is just income, so it is taxed as ordinary income. Capital gains and losses come from trading the security. If a bond has been held to maturity, it was not traded and therefore cannot be a capital gain. Short term capital gain never applies to interest income. LO 4.e

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) The secured creditors because secured debt is always the most senior security B) Investors holding guaranteed bonds because guaranteed bonds provide an ironclad guarantee that the investors always get back the principal amount invested 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 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

Due to a sudden drop in earnings, the board of directors of Amalgamated Metal Industries (AMI) has voted to suspend all dividend payments this year. This would have the least effect on holders of AMI's A) cumulative preferred stock. B) callable preferred stock. C) senior claim preferred stock. D) subordinated debentures.

D Regardless of the level of seniority of a preferred stock, it comes behind any debt security. More importantly, interest on a debenture, subordinated or not, is a contractual obligation. Unlike the dividends on stock, the decision to pay or not to pay interest is not an optional one. Failure to pay interest on a debt security can lead to foreclosure and bankruptcy proceedings. 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) senior notes, preferred stock, common stock, general creditors. B) general creditors, senior notes, preferred stock, common stock. C) common stock, preferred stock, general creditors, senior notes. D) senior notes, general creditors, preferred stock, common stock.

D 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

An investor seeking income combined with a conservative level of risk would purchase A) junk bonds. B) AAA-rated convertible debentures. C) unrated income bonds. D) AA-rated mortgage bonds.

D The conservative level of risk eliminates the income bonds and the junk bonds. Income bonds pay interest only if the issuer has the funds to do so. Junk bonds are named such because of their high risk. Even though the convertible debentures have a higher rating than the mortgage bonds, the difference is relatively insignificant at that level and either would be suitable for the conservative investor. However, because of the convertible feature, it is always true on the exam that the income return is lower than non-convertible issues. Therefore, the most suitable for this investor would be the mortgage bonds. 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) Treasury bills, convertible bond, income bond B) Convertible bond, income bond, nonconvertible bond C) Nonconvertible bond, convertible bond, income bond D) Income bond, convertible bond, nonconvertible bond

D 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

All the following statements concerning zero-coupon bonds are true except A) zero-coupon bonds may be issued by the U.S. Treasury, corporations, and state and local governments. B) zero-coupon bonds pay no interest during the life of the bond. C) zero coupon bonds are most often issued with long-term maturities. D) zero-coupon bond prices are more stable than other types of bonds.

D Zero-coupon bonds pay no interest during the life of the bond. Rather, investors purchase zeros at a deep discount from par. The difference between the discounted price and the maturity value is the interest the investor receives from the bond. In other words, zeros pay no interest until maturity. The effect of this is that their prices fluctuate more than other types of bonds when traded on the secondary market. Investors typically pay income tax on the phantom interest as it accrues each year. LO 4.e