Series 7 - EQUITIES: Preferred Stock

Preferred stock has all of the following features as compared to common stock EXCEPT: A. fixed rate of return B. fixed maturity C. priority claim to dividends declared D. priority claim to assets upon dissolution

The best answer is B. Preferred stock does not have a stated maturity - it has an indefinite life. Preferred stock does have a stated dividend rate and priority claim to both dividends and corporate assets over common stock.

All of the following are terms associated with preferred stock EXCEPT: A. callable B. cumulative C. redeemable D. convertible

The best answer is C (Pref. Stock is not redeemable) Preferred stock is not a redeemable security - it is a negotiable security. The stock cannot be redeemed with the issuer - an investor who wishes to liquidate must sell the stock in the market. Preferred stock can be callable, cumulative, and convertible.

Which statements are TRUE about preferred stock? I When interest rates rise, preferred stock prices rise II When interest rates rise, preferred stock prices fall III When interest rates fall, preferred stock prices fall IV When interest rates fall, preferred stock prices rise A. I and II B. I and III C. II and III D. II and IV

The best answer is D. Preferred stock is a fixed income security, and hence, when market interest rates move, the only way for the yield on the security to adjust to the market is to have the price change. When interest rates rise, preferred stock prices fall, increasing the yield on the security; and when interest rates fall, preferred stock prices rise, decreasing the yield on the security.

ABC 8% $100 par preferred is trading at $120 in the market. The current yield is: A. 6.7% B. 8.6% C. 10.6% D. 60.6%

The best answer is A (6.7%). The formula for current yield is: Annual Income (dividend) / MRKT. Price = Current Yield $8 = 6.7%

Preferred dividends may be paid as: I Cash II Stock III Stock of another company A. I only B. II only C. I or II D. I, II, III

The best answer is A (Cash Only). Preferred dividends may only be paid in cash. This differs from common stock, which can be paid a dividend in the form of cash, stock, or product.

A middle-aged widowed customer has an investment objective of stable income and would also like to receive occasional "extra" income to help pay unexpected bills. What type of preferred stock would be the best recommendation? A. Participating preferred B. Convertible preferred C. Straight preferred D. Variable rate preferred

The best answer is A (Participating Pref). Preferred stock that pays a fixed dividend rate is "straight" preferred. Participating preferred receives the fixed dividend rate, and also participates with common in any "extra" dividends paid by the company - so this meets the customer's investment objective. Convertible preferred has a fixed dividend rate that is lower than straight preferred, but in compensation for this, it can be converted into a predetermined number of common shares at the option of the holder. Thus, the holder can have capital gains if the market price of the common stock rises. Variable rate preferred has a dividend rate that is tied to a market rate of interest, and the dividend rate varies as that rate varies - so it does not meet the customer's objective of stable income.

A corporation issues $100 par convertible preferred stock, convertible at $10 per share, when the market price of the common is currently $5. Which statement is TRUE? A. The conversion ratio is 10:1 B. The conversion ratio is 5:1 C. The conversion ratio is 2:1 D. The conversion ratio cannot be determined

The best answer is A (The conversion ratio is 10:1). The conversion ratio is Par Value / Conversion Price. $100 Par / $10 Conversion Price = 10:1 Conversion Ratio.

ABC Company has issued 13%, $100 par cumulative preferred stock. Two years ago, ABC paid a preferred dividend of $8. Last year, it paid a preferred dividend of $12 per share. This year, ABC wishes to pay a common dividend. In order to make the distribution to common shareholders, each preferred share must be paid a dividend of: A. $14 B. $19 C. $20 D. $26

The best answer is B ($19). Since the preferred stock is cumulative, to make a dividend distribution to common shareholders, the company needs to pay all back, unpaid dividends plus this year's dividend (before a common dividend can be paid). The stated dividend rate on the preferred is 13% based on $100 par. Two years ago, 8% was paid, so 5% was omitted that must be paid. Last year, the corporation only paid 12%, so there is another 1% that must be paid. Also, this year's dividend of 13% must be paid. The total dividend that must be paid is 19% or $19 per preferred share before a common dividend can be paid.

A customer buys 100 shares of preferred at $101 per share. The par value is $100. The dividend rate is 8%. Each dividend payment will be: A. $80 B. $400 C. $800 D. $808

The best answer is B ($400). The annual rate is 8% X $100 par value = $8 per share X the number of shares = $800. Since preferred dividends are paid semi-annually, each payment would be $400.

Preferred stock is issued with an "anti-dilutive" covenant. If the corporation declares a 5% stock dividend, which statements are TRUE? I The conversion ratio is increased II The conversion price is increased III The conversion ratio is decreased IV The conversion price is decreased A. I and II B. I and IV C. II and III D. III and IV

The best answer is B (Conv. ratio Increases & Conv. price decreases). When a senior convertible security is issued with an "anti-dilutive" covenant, should the company issue additional common shares, the terms of conversion are adjusted. When additional common shares are issued, there are more common shares outstanding, with each share being worth proportionately less. To adjust the terms of conversion, the conversion price is reduced, and the number of common shares into which the security is convertible (the conversion ratio) is increased.

Which of the following are types of preferred stock? I Performance II Participating III Cumulative IV Refundable A. I and III only B. II and IV only C. I, II, III D. I, II, III, IV

The best answer is C (all but refundable). There is no such thing a refundable preferred stock. Participating preferred (aka performance preferred) allows the holder to receive additional dividend distributions from the issuer if the issuer is having a good year. Cumulative preferred "accumulates" any unpaid dividends. Before a common dividend may be paid, all accumulated dividends must be paid to cumulative preferred shareholders.

Preferred stocks are most often suitable investments for the: A. individual B. corporate investor C. partnership investor D. fiduciary investor

The best answer is B (corporate investor). Corporations that receive dividends from investments held generally are allowed to exclude 50% of the dividends received from taxation. This exclusion does not apply to individual investors (however, individual investors get the benefit of taxation of cash dividends received at a substantially lower rate - 15% (or 20% for those in the highest tax bracket) - than do corporate investors). Thus, a corporation that receives dividends from common stock holdings, preferred stock holdings, or mutual fund holdings where the fund's income is from common and/or preferred stock investments, is allowed to exclude 50% of that income from taxation

A corporation has issued $100 par, 8% cumulative convertible preferred stock, callable at par. The preferred is convertible into 1.4 shares of common stock. Currently, the preferred stock is trading at $102 while the common stock is trading at $75.50. The corporation calls the preferred stock at par plus accrued dividends of $2 per share. The corporation is making a(n): A. tender offer B. forced conversion C. advance refunding D. simultaneous transaction

The best answer is B (forced conversion). If a preferred stockholder converts and sells the stock in the market, he realizes the equivalent of 1.4 (conversion ratio) x $75.50 current market price = $105.70 per share. If he or she tenders the preferred on the call, he or she receives $100 per share. He or she will not continue to hold the preferred since dividend payments will cease. The best choice for the preferred shareholder is to convert. In effect, the corporation is forcing the shareholders to convert to common.

A corporation issues $100 par convertible preferred stock, convertible at $20 per share when the common stock is trading at $10. The preferred is issued under an "anti-dilutive covenant." If the company declares a 25% stock dividend, which statements are TRUE? I The conversion price is adjusted to $16 II The conversion price is adjusted to $25 III The conversion ratio is adjusted to 4:1 IV The conversion ratio is adjusted to 6.25:1 A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. Under an "anti-dilutive" covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $20 per share. If there is a 25% stock dividend, the new conversion price will be adjusted to $20/1.25 = $16 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/$16 = 6.25.

A corporation has issued $100 par, 6 1/2% cumulative convertible preferred stock, callable at par. The preferred is convertible into 2 shares of common stock. Currently, the preferred stock is trading at $98 while the common stock is trading at $52. If a customer buys 100 preferred shares, converts, and then sells the common stock in the market, the profit or loss is (ignoring commissions): A. $200 gain B. $600 gain C. $4,600 gain D. $5,200 gain

The best answer is B. If the customer buys 100 shares of the preferred stock, he or she will pay 100 x $98 per share = $9,800. Since each share of preferred is convertible into 2 common shares, the 100 preferred shares will be converted into 2 x 100 = 200 common shares. The sale of 200 common shares at the current market price of $52 will yield $10,400. The net profit is: $10,400 - $9,800 = $600.

XYZ Company has issued 10%, $100 par non-cumulative preferred stock. Two years ago, XYZ omitted its preferred dividend. Last year, it paid a preferred dividend of $5 per share. This year, XYZ wishes to pay a common dividend. In order to make the distribution to common shareholders, each preferred share must be paid a dividend of: A. 0 B. $5 C. $10 D. $15

The best answer is C ($10). Since the preferred stock is noncumulative, to make a dividend distribution to common shareholders, the company need only make this year's preferred dividend distribution. The stated dividend rate on the preferred is 10% based on $100 par, so $10 of preferred dividends must be paid per share. If this preferred were cumulative, then all omitted dividends must be paid before a distribution can be made to common. Please note that almost all preferred stock issues are cumulative - but non-cumulative issues must still be known for the exam.

ABC Company has outstanding 10% noncumulative preferred stock. Two years ago, ABC paid a 6% preferred dividend. Last year, ABC paid a 7% preferred stock dividend. This year, ABC wishes to pay a common dividend. The preferred shareholders must receive: A. 0% B. 7% C. 10% D. 17%

The best answer is C (10%). Since this is noncumulative preferred stock, the corporation will only have to pay 10% - or this year's dividend, before paying a common dividend. Please note that virtually every preferred issue is cumulative - noncumulative issues are basically unmarketable. However, noncumulative preferred stock must be known for the exam!

Income from which of the following securities is partially tax exempt to a corporate investor? I Common Stock II Preferred Stock III Preferred Stock Mutual Fund IV Convertible Bonds A. I only B. II and III only C. I, II, III D. I, II, III, IV

The best answer is C (CS, PS, PSMF). Corporations that receive dividends from investments held generally are allowed to exclude 50% of the dividends received from taxation. This exclusion does not apply to individual investors (however, individual investors get the benefit of taxation of cash dividends received at a substantially lower rate - 15% (or 20% for those in the highest tax bracket) - than do corporate investors). Thus, a corporation that receives dividends from common stock holdings, preferred stock holdings, or mutual fund holdings where the fund's income is from common and/or preferred stock investments, is allowed to exclude 50% of that income from taxation. This tax benefit for corporate investors does not apply to interest received from bond holdings.

All of the following statements are true about preferred stock EXCEPT: A. Preferred dividends are paid before common B. In most cases dividends are paid semi-annually C. Corporations must pay preferred dividends D. Preferred shareholders are paid before common shareholders upon liquidation of a corporation

The best answer is C (Corporations must pay preferred dividends) Preferred stock has preference over common as to the payments of dividends and as to assets upon liquidation. Preferred dividends are, in most cases, paid semi-annually. The Corporation will only pay the preferred dividend if the Board of Directors decides. There is no legal obligation to pay the preferred, however, if it is not paid, investors will not find the stock attractive and won't invest in it.

If interest rates fall, issuers most likely will call: I low dividend rate preferred issues II high dividend rate preferred issues III preferred issues trading at a premium IV preferred issues trading at a discount A. I and III B. I and IV C. II and III D. II and IV

The best answer is C (high div. rate pref issues & pref issues trading @ premium) If interest rates fall, issuers most likely will "call in" old high rate preferred and replace it by selling new preferred at the lower current rates. High rate preferred will sell at a premium if market interest rates are dropping.

Which statements are TRUE regarding participating preferred stock? Participating preferred: I participates in any bond interest payments II participates in "extra" common dividends declared by the Board of Directors III has a dividend rate that is fixed as to a minimum but not as to a maximum IV has a dividend rate that is fixed as to a maximum but not as to a minimum A. I and III B. I and IV C. II and III D. II and IV

The best answer is C. (participates in "extra" common dividends declared by the Board of Directors & has a dividend rate that is fixed as to a minimum but not as to a maximum) Participating preferred pays a fixed dividend rate but also participates with common in "extra" dividends declared by the Board of Directors. Therefore, the dividend is fixed as to the minimum amount but not as to the maximum amount.

A corporation issues $100 par convertible preferred stock, convertible at $8 per share when the market price of the common is $4. The preferred is issued under an "anti-dilutive covenant." If the company declares a 2:1 stock split, which statements are TRUE? I The conversion price is adjusted to $2 II The conversion price is adjusted to $4 III The conversion ratio is adjusted to 25:1 IV The conversion ratio is adjusted to 50:1 A. I and III B. I and IV C. II and III D. II and IV

The best answer is C. Under an "anti-dilutive" covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $8 per share. If there is a 2 for 1 stock split, the new conversion price will be adjusted to $8/2 = $4 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/4 = 25:1.

XYZ Company has issued 10%, $100 par cumulative preferred stock. Two years ago, XYZ omitted its preferred dividend. Last year, it paid a preferred dividend of $5 per share. This year, XYZ wishes to pay a common dividend. In order to make the distribution to common shareholders, each preferred share must be paid a dividend of: A. $5 B. $15 C. $20 D. $25

The best answer is D ($2). Since the preferred stock is cumulative, to make a dividend distribution to common shareholders, the company needs to pay all back, unpaid dividends plus this year's dividend (before a common dividend can be paid). The stated dividend rate on the preferred is 10% based on $100 par. Two years ago the entire dividend was omitted, so $10 per share must be paid. Last year, the corporation only paid $5, so there is another $5 that must be paid. Also, this year's dividend of $10 must be paid. The total dividend that must be paid is $25 per preferred share before a common dividend can be paid.

ABC Company has issued 10% cumulative preferred stock. Two years ago, ABC paid a 6% preferred dividend. Last year, ABC paid a 7% preferred dividend. This year, ABC wishes to pay a common dividend. The preferred shareholders must receive: A. 0% B. 7% C. 10% D. 17%

The best answer is D (17%). Since this is cumulative preferred stock, all missed dividends must be paid before a common dividend can be paid. Two years ago, 4% was missed; last year 3% was missed; and this year's preferred dividend of 10% must be paid before the common dividend is paid. The total preferred dividend to be paid is 17%.

Which security of the same issuer is likely to give the highest current yield? A. warrant B. common stock C. convertible preferred stock D. non-convertible preferred stock

The best answer is D (Warrant). Warrants give no yield. Common stocks give the lowest yields since there is direct growth potential in the price of the stock as reported earnings increase. Convertible preferred yields are higher than common yields but not as high as non-convertible yields. A non-convertible preferred stockholder gets a fixed rate of return without any growth potential. A convertible preferred stockholder can convert to common if the common's price rises, so growth potential is included. Because of this, yields for convertible preferred are lower than for non-convertible preferred.