Series 7 Unit 3 (part 2)

Which of the following have equity positions in a corporation? I. Common stockholders II. Preferred stockholders III. Convertible bondholders IV. Mortgage bondholders

C) I and II Common and preferred stockholders have equity, or ownership, positions. Bondholders (mortgage or otherwise) are creditors, not owners. LO 3.a

All of the following are subject to the 5% markup policy except A) markups. B) markdowns. C) spreads in new stock offerings. D) commissions.

C) spreads in new stock offerings. The 5% markup policy applies to markups, markdowns, and commissions. New offerings sold by prospectus are exempt from this rule. LO 3.j

All of the following statements regarding the over-the-counter (OTC) market are true except A) it trades unlisted securities. B) it trades listed securities. C) more issues trade OTC than on the exchanges. D) it is an auction market.

D) it is an auction market. The OTC market is a negotiated market. The exchanges are auction markets. LO 3.h

The rate on an adjustable preferred stock may be indexed to A) the Treasury bill rate. B) the Producer Price Index. C) the Dow Jones Industrial Average. D) the Consumer Price Index.

A) the Treasury bill rate. The dividend on an adjustable rate preferred stock is tied to a particular interest rate, and the Treasury bill rate is a common benchmark. LO 3.e

A convertible preferred stock issue (par value $100) is selling at $125 and is convertible into five shares of common stock. The conversion price of the common stock is A) $100. B) $20. C) $25. D) $1,200.

B) $20. Par value divided by conversion price equals the number of shares into which the security is convertible. If this security is convertible into five shares, we need to know what number goes into $100 five times. That number is $20. The current market value of the preferred stock is unnecessary information. LO 3.e

Aenical Corporation issued $100 million of $100 par value preferred stock a number of years ago. The stock pays semiannual dividends of $1.25. Recent issues of comparable preferred stock carry a dividend yield of 10%. One could expect the market price of the Aenical preferred stock to be closest to A) $75. B) $100. C) $25. D) $50.

C) $25. As with other fixed-income securities, as market yields change, the price of previously issued securities increase or decrease to offer a comparable return. The logic is that investors will purchase fixed-income securities only if they can receive a return comparable to the current market rate. This stock is paying an annual dividend of $2.50 ($1.25 every six months). If not stated, dividends are always paid quarterly. This question specifically states the dividends are semiannual; do not get tripped up with something like this on the exam. Investors will be most interested in this stock if their return will be approximately 10%, the current rate being paid in the market. The math here must first answer "$2.50 is 10% of what number?" Divide $2.50 by 10% and the answer is $25. At $25 per share, Aenical stock paying a $2.50 annual dividend is offering a 10% return on investment. LO 3.e

XYZ Corporation, whose common stock is currently selling for $40 per share, is having a rights offering. The terms of the offering require 10 rights plus $35 to subscribe to one share of stock. Compute the theoretical value of a right before the ex-rights date. A) $0.55 B) $0.50 C) $3.50 D) $0.45

D) $0.45 Because the stock is trading with rights (before the ex-rights date), the formula is (M ‒ S ) divided by (N + 1). Plugging the numbers in, we have ($40 ‒ $35) divided by (10 + 1) = $5.00 ÷ 11 = $0.45. LO 3.f

Certificates issued by U.S. domestic banks and trust companies against the deposit of shares of foreign securities are known as A) American depositary receipts. B) certificates of deposit. C) American share receipts. D) foreign depositary receipts.

A) American depositary receipts. This is the definition of the ADR - the simplest way to trade foreign securities in the United States. LO 3.g

The Securities Exchange Act of 1934 applies to all of the following except A) regulation of new issues. B) secondary market trading. C) registration of broker-dealers. D) the extension of credit on purchase of securities.

A) regulation of new issues. The Securities Act of 1933 deals with new issues. The Securities Exchange Act of 1934 created the SEC, required the registration of broker-dealers, empowered the Federal Reserve to control the extension of credit on securities transactions, and created rules dealing with secondary market trading. LO 3.h

Without an exemption, member firms are required to provide purchasers of penny stocks each of the following except A) compensation to be earned by both the member firm and the associated person. B) quarterly statements. C) a risk disclosure document. D) current inside bid and ask quotation.

B) quarterly statements. If an exemption is not available, purchasers of penny stocks must receive the risk disclosure document, current inside bid and ask quotation, information on the compensation to be received by both the representative and the member in connection with the transaction, and monthly, not quarterly, statements. LO 3.j

The over-the-counter (OTC) market could be characterized as what type of market? A) Auction B) First C) Dealer D) Primary

C) Dealer The OTC market is a dealer market. LO 3.h

Stockholders' preemptive rights include the right to A) maintain proportionate ownership interest in the corporation. B) purchase Treasury stock. C) serve as an officer on the board of directors. D) sell stock back to the issuing corporation.

A) maintain proportionate ownership interest in the corporation. Preemptive rights allow stockholders to maintain their proportionate ownership when the corporation wants to issue more stock. For example, if a stockholder owns 5% of the outstanding stock and the corporation wants to issue more stock, the stockholder has the right to purchase 5% of the new shares. LO 3.c

GC, Inc., is proposing an additional public offering of common stock. It conducts a rights offering to its current shareholders at $55 per share, plus five rights. If the market price of GCI is $70 after the ex-rights date passes, what is the value of one right? A) 15 B) 3 C) 2.5 D) 5

B) 3 Because the stock is selling ex (after ex-rights), the formula is ($70 − $55) / 5. ($70 − $55 = $15) ($15 / 5 = $3). LO 3.f

A Nasdaq market maker buys 1,000 shares of stock from a customer at its bid to satisfy a customer order. This is an example of A) a riskless principal trade. B) a principal trade. C) a block trade. D) an agency trade.

B) a principal trade. The market maker is acting in a principal (dealer) capacity. LO 3.h

All of the following considerations apply to the 5% markup policy except A) the services rendered by the broker-dealer. B) the customer's ability to pay. C) the cost of executing the transaction. D) the availability of the security.

B) the customer's ability to pay. The 5% policy is a guideline for markups and commissions for exchange and over-the-counter trades. A firm cannot charge a higher commission or markup to a customer on the basis of the customer's ability to pay. Factors relevant in determining the fairness of a commission or markup include the type of security, the services rendered by the firm, and the expenses and difficulty of executing a particular trade. LO 3.j

A company that has issued cumulative preferred stock A) pays the current dividends on the preferred, but not the past dividends on the preferred, before paying a dividend on the common. B) pays the preferred dividend before paying the coupons due on its outstanding bonds. C) pays past and current preferred dividends before paying dividends on common stock. D) forces conversion of the preferred that is trading at a discount to par, thereby eliminating the need to pay past-due dividends.

C) pays past and current preferred dividends before paying dividends on common stock. Current and unpaid past dividends on cumulative preferred stock must be paid before common stockholders can receive a dividend. Bond interest is always paid before dividends. Dividends in arrears on cumulative preferred have the highest priority of dividends to be paid. LO 3.e

A convertible preferred stock with a par value of $100 is currently trading at $125 per share. The conversion ratio is 5:1. If the common stock is trading at $30 per share, what must the preferred stock's price be to be at parity? A) $130 B) $70 C) $103 D) $150

D) $150 The math is 5 × $30 = $150. The logic is, you can convert the preferred stock into five shares of the common. If the common is trading at $30 per share, to be equal, the preferred stock must be selling for five times that price. LO 3.e

Four years ago, you declared a net capital loss of $23,000 on your tax return. You have had no further capital gains or losses since then. For that year and the next two, you took the maximum allowable income deduction. How much may you deduct from your income this year, and how much loss will you have to carry forward? A) $2,000/$12,000. B) $2,000/$11,000. C) $3,000/$12,000. D) $3,000/$11,000.

D) $3,000/$11,000. The maximum allowable deduction against income is $3,000. You will have taken four such deductions against $23,000, which leaves you with $11,000 to carry forward ($23,000 - $12,000). LO 3.i

By regular or statutory voting procedures, a shareholder with 100 shares would be able to vote to fill seats for six directors in which of the following ways? A) 100 votes for each of the six candidates B) 300 votes for any two, none for the other four C) 150 votes for any four candidates D) 600 votes for any one director, no votes for the others

A) 100 votes for each of the six candidates With regulatory or statutory voting, the investor has one per share per vacant seat. In this case, this is 100 shares for each of the six open seats. Any of the choices would work for cumulative voting. LO 3.c

A participating preferred stock A) receives both a fixed dividend plus a share of the common dividend. B) must be paid any dividend arrearage before dividends may be paid on the common stock. C) participates in voting along with the common shareholders. D) has a senior claim in liquidation over holders of debentures.

A) receives both a fixed dividend plus a share of the common dividend. In addition to the stated fixed dividend, participating preferred stock is eligible to receive a percentage of the common dividend. The participation has nothing to do with voting. Any preferred stock, although senior to common, has a junior claim to any debt security. It is the cumulative preferred where there is the obligation to clear up the arrearage before paying dividends on the common stock. LO 3.e

All of the following are advantages of investing in American depositary receipts (ADRs) except A) ADRs fall under the oversight of the SEC. B) currency risk is virtually eliminated. C) transactions are done in U.S. currency. D) dividends are received in U.S. currency.

B) currency risk is virtually eliminated. ADRs carry currency risk because distributions on ADRs must be converted from foreign currency to U.S. dollars on the date of distribution. In addition, the trading price of the ADR is affected by foreign currency fluctuation. LO 3.g

One of your clients owns 300 shares of common stock in a publicly traded corporation. The acquisition cost of those shares was $60,000 and the last trade of the stock was $220 per share. There was a news report that the company was going to pay shareholders a 100% stock dividend. The client wants to know how this dividend will affect the holding. You would respond that the customer will A) now own 600 shares and the market price will be approximately $220 per share. B) now own 600 shares and the market price will be approximately $110 per share. C) now own 150 shares and the market price will be approximately $440 per share. D) still own 300 shares and the market price will be approximately $440 per share.

B) now own 600 shares and the market price will be approximately $110 per share. The effect of a 100% stock dividend is the same as a 2:1 stock split. The customer will have twice as many shares worth half as much each. That would be 600 shares worth $110 per share for a total value of $66,000. Note that the total value is unchanged from the pre-split value of 300 shares at $220 per share. LO 3.b

Owners of a corporation's common stock who are unable to attend the corporation's annual meeting are A) forfeiting their right to vote. B) sent proxies to cast their votes. C) required to give voting instructions to the broker-dealer handling the account. D) unable to change their vote if they should be able to attend the meeting.

B) sent proxies to cast their votes. A proxy is this industry's version of an absentee ballot. Most are handled electronically now. Should the situation change and the individual be able to make the meeting, the vote can be changed at that time if desired. The broker-dealer handling the account is frequently the one who solicits the proxy on behalf of the issuer. There is no action taken against a client who ignores the proxy, just as nothing happens to a citizen who decides not to vote in an election. LO 3.d

A corporation pays a 10% stock dividend to common stockholders. All the following are true regarding this dividend except A) the total value of the position is unchanged when the dividend is paid. B) the beauty of stock dividends is that they are nontaxable. C) the cost basis per share is adjusted based on the stock dividend. D) the dividend is taxable in the year the sale of the shares takes place.

B) the beauty of stock dividends is that they are nontaxable. The stock dividend is taxable, but unlike cash dividends, which are taxed when received, stock dividends are taxable in the year the shares are sold. When the stockholder receives the additional shares, the cost basis is adjusted on a per-share basis with the total value of the position remaining unchanged. For example, if an investor owned 100 shares purchased at a price of $22 per share and the company paid a 10% stock dividend, the numbers would look like this. The number of shares owned is now 110 [100 + (10% of 100)] = 100 + 10. The adjusted cost basis per share (used when any of the shares are sold) is now $20 per share. The original cost is $2,200 (100 shares times $22 per share). After the stock dividend, the customer owns 110 shares, but there was no additional cost. Divide that original $2,200 by the new number of shares ($2,200 divided by 110) to arrive at an adjusted cost basis of $20 per share. The account value is still $2,200 (110 shares times $20 per share = $2,200). LO 3.i

Marcus owns 5,000 shares of KYZ stock. He recently received proxies in the mail. Marcus would be able to use the proxies for all of the following except A) to vote for three members of the board of directors. B) to buy additional shares of KYZ common stock after the stock splits 2:1. C) to vote on the proposed issuance of 100,000 shares of convertible preferred stock. D) to vote on a proposed 2:1 stock split.

B) to buy additional shares of KYZ common stock after the stock splits 2:1. A proxy is a form of absentee ballot used by stockholders to vote on company matters such as stock splits, members of the board of directors, and issuance of additional equity-related securities such as convertible securities. Stockholders do not vote on dividend-related matters, nor are proxies used to purchase shares of stock. LO 3.c

One of your clients asks about a recent purchase of a preferred stock. When looking at online information about the stock, the client notices that no par value is assigned. How does the company determine the amount of dividend to be paid? A) On a no-par preferred stock, the company has the flexibility to increase or decrease the dividend as earnings warrant. B) On a no-par preferred stock, the dividend is paid as a percentage of the common stock dividend. C) On a no-par preferred stock, the dividend is a stated rate. D) The board of directors determines the amount each quarter based on current interest rates.

C) On a no-par preferred stock, the dividend is a stated rate. When a preferred stock is issued without a stated or par value, the dividend rate is stated in dollars. For example, it could be a $2 preferred. That would mean quarterly dividends of $0.50; $2 per year. Although the company is under no obligation to pay a preferred dividend (unless it plans to pay a dividend on its common stock), and the board of directors can pay a partial dividend, that does not mean the dividend can be increased over the stated rate. LO 3.e

The 5% markup policy applies to A) new issues. B) mutual funds. C) principal over-the-counter (OTC) trades. D) all of these.

C) principal over-the-counter (OTC) trades. The 5% markup policy applies to agency and principal nonexempt securities and transactions, both exchange and OTC traded. It does not apply to prospectus offerings (mutual funds and new issues). LO 3.j

Lambda Corporation has received a donation of 100,000 shares of its common stock from the spouse of the deceased founder of the company. This would appear on the company's books as A) unissued stock. B) authorized, but unissued stock. C) treasury stock. D) reacquired stock.

C) treasury stock. When a corporation reacquires shares of outstanding stock, whether through open market purchase or, as in this case, donation, the stock is treasury stock. LO 3.a

An investor purchased 200 shares of Hightown National Bank (HNB) common stock at $120.06 per share. Thirteen months later, HNB pays a 15% stock dividend. Three months after that, the investor sells the shares received from the stock dividend at $112.57 per share. The tax consequence to the investor is A) $245.10 short-term capital gain. B) $122.55 short-term capital gain. C) $1,879.10 long-term capital gain. D) $245.10 long-term capital gain.

D) $245.10 long-term capital gain. The total value of the initial position is unchanged, remaining at $24,012 (200 times $120.06). After the stock dividend the investor owns 230 shares (200 times 15% = 30 + 200 = 230). Therefore, the adjusted cost basis is $104.40 per share ($24,012 divided by 230 = $104.40). The question tells us that the investor sells those 30 additional shares at $112.57 per share. That is a difference of $8.17 per share. Multiply that gain by 30 shares and the result is a profit of $245.10. It is a long-term gain because the holding period of shares received from a stock dividend or stock split begins with the initial purchase, not the receipt of the new shares. It is important to remember that anytime there is a distribution resulting in additional shares (stock split, stock dividend), the cost basis per share is reduced while the total account value remains the same. If you have to guess, or are running out of time, when you see two identical numbers with the only difference being short- or long-term gain, in almost all questions, one of those two is the correct answer. Now you have a 50% chance of guessing correctly and, if you remember that the holding period always begins with the initial purchase, then the odds are 100% in your favor. LO 3.i

If a corporation attaches warrants to a new issue of debt securities, which of the following would be a resulting benefit to the corporation? A) Dilution of shareholders' equity B) Increase in earnings per share C) Reduction of the number of shares outstanding D) Reduction of the debt securities' interest rate

D) Reduction of the debt securities' interest rate Usually, a warrant is issued along with a debt instrument, which is an enhancement that allows the issuer to offer a slightly lower interest rate. LO 3.f

Which of the following statements regarding warrants is true? A) Warrants are safer than corporate bonds. B) Warrants' terms are generally shorter than rights' terms. C) Warrants give the holder a perpetual interest in the issuer's stock. D) Warrants are often issued with other securities to make the offering more attractive.

D) Warrants are often issued with other securities to make the offering more attractive. Warrants are generally issued with bond offerings to make the bonds more attractive. Warrants are long-term options to buy stock, and because they are equity securities, warrants, as investments, are considered less safe than bonds. LO 3.f

An investor establishes a $5,000 position by purchasing 100 shares at $50 per share. She then sells all the shares six months later at $60 per share. Her taxable consequences are A) a $6,000 short-term capital gain. B) a $1,000 long-term capital gain. C) a $1,000 short-term capital loss. D) a $1,000 short-term capital gain.

D) a $1,000 short-term capital gain. The taxable consequence for this investor is a $1,000 short-term capital gain. She sold shares for $6,000 and purchased them for $5,000 resulting in a $1,000 gain. It is short-term gain because she did not hold the shares longer than one year. Short-term capital gains are taxed as ordinary income at the investor's marginal tax rate. Long-term capital gains are taxed at lower tax rates. LO 3.i

All of the following securities trade in the over-the-counter (OTC) market except A) Nasdaq securities. B) government and agency securities. C) American depositary receipts. D) open-end investment companies.

D) open-end investment companies. Municipal bonds, government and agency securities, and corporate securities (listed and unlisted) all trade in the OTC market. Foreign securities trade in the United States if the companies comply with SEC registration and disclosure requirements. Mutual fund shares (open-end companies) do not trade. LO 3.h

Issued and outstanding stock is the authorized stock of a corporation that has been purchased by investors. The remaining authorized but unissued stock may be used for all of the following except A) paying stock dividends to stockholders. B) exchanging stock with stockholders in a conversion. C) raising capital at a later date. D) sending to the IRS for payment of federal income taxes.

D) sending to the IRS for payment of federal income taxes. The IRS does not want a corporation's authorized but unissued stock to pay federal income taxes. The IRS treats a corporation as an entity like an individual taxpayer and wants money, not stock. This unissued stock can be issued to raise future capital, used to pay stock dividends, and to exchange for convertible preferred stock and convertible bonds upon conversion. LO 3.a

An investor purchasing an ADR for a company domiciled in South Korea should understand that A) any Korean taxes on dividends will be added to U.S. tax on those dividends. B) the investor will not be able to receive a stock certificate for that company. C) the ADR has greater market risk than the stock itself. D) the investor will be subject to currency risk.

D) the investor will be subject to currency risk. ADRs facilitate the purchase of foreign stock. This is because everything is in dollars and English. However, because the trading price and value of this security is based on the South Korean won, U.S. investors have currency (exchange) risk. Although not commonly done, investors can request the actual certificate to replace the ADR. There is a withholding tax in Korea, but as with any ADR on the exam, that tax paid may be taken as a credit against the U.S. tax due on the dividend. There is essentially no difference in market risk between the actual stock and the ADR. LO 3.g