CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND
CONVERTIBLES
TRUE/FALSE
1. The “preferred” feature of preferred stock means that it normally will provide a higher expected return
than will common stock.
2. Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax
basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is
deductible.
3. A warrant is an option, and as such it cannot be used as a “sweetener.”
4. A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the
underlying stock.
5. The problem of dilution of stockholders’ earnings never results from the sale of call options, but it can
arise if warrants are used.
6. A detachable warrant is a warrant that can be detached and traded separately from the bond with which
it was issued. Most traded warrants are originally attached to bonds or preferred stocks.
7. The owner of a convertible bond owns, in effect, both a bond and a call option.
8. A convertible debenture can never sell for more than its conversion value or less than its bond value.
9. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions,
can be exchanged for common stock at the option of the holder.
10. Firms generally do not call their convertibles unless the conversion value is greater than the call price.
11. Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been
omitted for some specified period, for example, 4 quarters.
12. Preferred stockholders have priority over common stockholders with respect to dividends, because
dividends must be paid on preferred stock before they can be paid on common stock. However,
preferred and common stockholders normally have equal priority with respect to liquidating proceeds
in the event of bankruptcy.
13. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The
par value is also important in the event of liquidation, as the preferred stockholders are generally
entitled to receive the par value before anything is given to the common stockholders.
14. Preferred stock can provide a financing alternative for some firms when market conditions are such
that they cannot issue either pure debt or common stock at any reasonable cost.
15. Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively
stable price, which is desirable for liquidity portfolios, and they also benefit from the 70% tax
exemption on preferred dividends received.
MULTIPLE CHOICE
16. Which of the following statements is most CORRECT?
a.
By law in most states, all preferred stock must be cumulative, meaning that the
compounded total of all unpaid preferred dividends must be paid before any dividends can
be paid on the firm’s common stock.
b.
From the issuer’s point of view, preferred stock is less risky than bonds.
c.
Whereas common stock has an indefinite life, preferred stocks always have a specific
maturity date, generally 25 years or less.
d.
Unlike bonds, preferred stock cannot have a convertible feature.
e.
Preferred stock generally has a higher component cost of capital to the firm than does
common stock.
17. Which of the following statements about convertibles is most CORRECT?
a.
One advantage of convertibles over warrants is that the issuer receives additional cash
money when convertibles are converted.
b.
Investors are willing to accept a lower interest rate on a convertible than on otherwise
similar straight debt because convertibles are less risky than straight debt.
c.
At the time it is issued, a convertible’s conversion (or exercise) price is generally set equal
to or below the underlying stock’s price.
d.
For equilibrium to exist, the expected return on a convertible bond must normally be
between the expected return on the firm’s otherwise similar straight debt and the expected
return on its common stock.
e.
The coupon interest rate on a firm’s convertibles is generally set higher than the market
yield on its otherwise similar straight debt.
18. Which of the following statements concerning warrants is correct?
a.
Warrants are long-term put options that have value because holders can sell the firm’s
common stock at the exercise price regardless of how low the market price drops.
b.
Warrants are long-term call options that have value because holders can buy the firm’s
common stock at the exercise price regardless of how high the stock’s price has risen.
c.
A firm’s investors would generally prefer to see it issue bonds with warrants than straight
bonds because the warrants dilute the value of new shareholders, and that value is
transferred to existing shareholders.
d.
A drawback to using warrants is that if the firm is very successful, investors will be less
likely to exercise the warrants, and this will deprive the firm of receiving any new capital.
e.
Bonds with warrants and convertible bonds both have option features that their holders can
exercise if the underlying stock’s price increases. However, if the option is exercised, the
issuing company’s debt declines if warrants were used but remains the same if it used
convertibles.
19. Which of the following statements is most CORRECT?
a.
One important difference between warrants and convertibles is that convertibles bring in
additional funds when they are converted, but exercising warrants does not bring in any
additional funds.
b.
The coupon rate on convertible debt is normally set below the coupon rate that would be
set on otherwise similar straight debt even though investing in convertibles is more risky
than investing in straight debt.
c.
The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to
buy a risky, volatile stock, other things held constant.
d.
Warrants can sometimes be detached and traded separately from the debt with which they
were issued, but this is unusual.
e.
Warrants have an option feature but convertibles do not.
20. The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures
(issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common
stock at any time before 2025. What is the conversion value of the bond?
a.
$707.33
b.
$744.56
c.
$783.75
d.
$825.00
e.
$866.25
21. Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any
time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of
common stock. What is the conversion price, Pc?
a.
$40.00
b.
$42.00
c.
$44.10
d.
$46.31
e.
$48.62
22. Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers
also stated that the company can sell an issue of annual payment preferred stock to corporate investors
who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that
exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium.
What coupon rate must be set on the preferred in order to issue it at par?
a.
6.66%
b.
6.99%
c.
7.34%
d.
7.71%
e.
8.09%
23. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells
for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share
of stock at an exercise price of $47. The firm’s straight bonds yield 10%. Each warrant is expected to
have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the
company set on the bonds in order to sell the bonds-with-warrants at par?
a.
7.83%
b.
8.24%
c.
8.65%
d.
9.08%
e.
9.54%
24. McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-
year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder
the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant
will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon
rate should be set on the bonds-with-warrants so that the package would sell for $1,000?
a.
6.75%
b.
7.11%
c.
7.48%
d.
7.88%
e.
8.27%
25. Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and
an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar
straight bonds is 15%. What is the implied value of each warrant?
a.
$3.76
b.
$3.94
c.
$4.14
d.
$4.35
e.
$4.56
26. Mikkleson Mining stock is selling for $40 per share and has an expected dividend in the coming year
of $2.00, and has an expected constant growth rate of 5.00%. The company is considering issuing a
10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00%
annual coupon, and each bond could be converted into 20 shares of common stock. The required rate
of return on an otherwise similar nonconvertible bond is 10.00%. What is the estimated floor price of
the convertible at the end of Year 3?
a.
$794.01
b.
$835.81
c.
$879.80
d.
$926.10
e.
$972.41
27. Refer to Exhibit 20.1. What is the bond’s conversion ratio?
a.
27.14
b.
28.57
c.
30.00
d.
31.50
e.
33.08
28. Refer to Exhibit 20.1. What is the bond’s conversion value?
a.
$698.15
b.
$734.89
c.
$773.57
d.
$814.29
e.
$857.14
29. Refer to Exhibit 20.1. What is the bond’s straight-debt value?
a.
$684.78
b.
$720.82
c.
$758.76
d.
$798.70
e.
$838.63
30. Refer to Exhibit 20.1. What is the minimum price (or “floor” price) at which the Neuman’s bonds
should sell?
a.
$698.15
b.
$734.89
c.
$773.57
d.
$814.29
e.
$857.14
