Economics Chapter 19 1 Convertible Security Almost Always Security That

Chapter 19 Test Bank – Static Key

1. A convertible security is one that can be converted into common stock only at the option of the issuer.

2. If a $1,000 par value convertible bond has a conversion ratio of 1 bond to 70 shares, the bond

conversion price is $14.29.

3. The face value of a convertible bond divided by the conversion price equals the number of shares a

bondholder will receive upon conversion.

4. The conversion price divided into the market value of a convertible bond provides the conversion ratio.

5. The conversion premium represents the dollar difference between the conversion value and the pure

bond value.

6. The conversion premium is equal to the market price minus the conversion value.

7. Conversion premiums are found by subtracting the current stock price from the bond’s semi annual

interest payment.

8. Conversion premiums are influenced heavily by expectations of future stock performance.

9. A conversion premium is ultimately the additional amount given up to convert the bond to stock.

10. Generally, once a convertible bond trades at a certain premium to its intrinsic value, or at a certain

multiple of its conversion price, the bond must be converted into common stock.

11. A convertible bond has two separate sources of value: the bond investment value and the bond

conversion value.

12. A pure bond value is the vale of a non-convertible bond with the same amount of risk as the convertible

bond being measured.

13. A convertible bond carries an element of downside risk if its “floor value” were to exceed the price of

the company’s stock.

14. A convertible bond has both a downside limit (the pure bond value) and an upside limit (the conversion

price).

15. If market rates of interest change, the “floor value” of a convertible bond can change.

16. The floor value of a bond can change if market interest rates for competitive bonds change.

17. Convertible securities are attractive because of their downside protection characteristics, as well as

their upside potential.

18. For the most downside protection, an investor should search for convertibles trading below par value

near their floor value.

19. The downside protection of a convertible bond’s floor value insulates the investor from any possible

loss.

20. Generally speaking, convertible bonds reverse the risk-return trade-off that applies to most

investments.

21. The interest rate on convertible bonds is typically one-third higher than similar non-convertible issues.

22. If you purchased a convertible bond when first issued, you would pay more for the shares of stock you

are entitled to than if you purchased the shares directly on the market at that point in time.

23. The primary issuers of convertible bonds are smaller companies with low credit scores and high risk,

but are growing.

24. In general, the average size of convertible issues is small compared to normal bond issues.

25. On average, convertible bonds have conversion premiums of less than 10% at the time of issue.

26. A call provision is commonly used by a corporation to force conversion into common stock.

27. Forced conversion refers to the corporation calling a convertible bond. This is ideal when the market

price of the stock is above the conversion price by more than a small percentage.

28. A forced conversion will typically alter the corporate balance sheet favour ably.

29. Basic earnings per share includes all convertible bonds outstanding.

30. “Basic earnings per share” does not include the dilutive effects of all of a firm’s convertible bonds.

31. “Diluted earnings per share” must assume the conversion of all convertible securities, even if they

haven’t been converted.

32. In order to calculate basic earnings per share, the earnings after taxes must be adjusted for the

elimination of the convertible bond interest expense.

33. Warrants never sell for more than their intrinsic value.

Learning Objective: 19-04 Warrants are similar to convertibles in that they give the warrant holder the right to acquire common stock.

Topic: Warrants

34. A warrant may carry a speculative premium above intrinsic value if the warrant isn’t going to expire for a

while.

35. Because a warrant is dependent on the market movement of an underlying stock, it is highly

speculative in nature.

36. Warrants are similar to convertible debt in that they give the warrant holder the right to acquire common

stock.

37. Warrants are similar to convertible debt in that they require the issuance of debt in order to obtain the

right to acquire common stock.

38. Warrants are often attached to debt securities to increase the debt issue’s attractiveness to investors.

39. The premium for a warrant would increase if its underlying common stock has a negative market

outlook.

40. A warrant’s speculative premium equals the market price of the underlying common stock minus the

option price.

41. A warrant is of huge benefit to the warrant holder when the stock rises far above the exercise price.

42. A warrant is of huge benefit to the company when the stock rises far above the exercise price.

43. As a financing device for creating common stock, warrants are usually more desirable than convertible

bonds.

44. Warrants are considered in-the-money when the exercise price is above the current market price.

45. Warrants are considered in the computation of “diluted earnings per share,” but not in “basic earnings

per share.”

46. Theoretically, stock options are granted to employees so that the employees will make decisions that

benefit the owners or shareholders.

47. Most corporations include call provisions in agreements relating to the issue of warrants.

48. Forced conversions of convertible bonds occur when unethical corporate executives call corporate

bonds prematurely.

49. Convertible bonds and convertible preferred stock are used on a regular basis by corporations to

diversify their capital structure.

50. The conversion value is equal to the conversion ratio times the conversion price.

51. When the market price of a common stock rises above the conversion price, the convertible bond

should always be converted immediately before it drops.

52. The conversion premium of a convertible bond is generally greater when the market price of the stock

is below the conversion price.

53. Convertible bonds offer minimal risk of loss to the investor due to their floor value.

54. Investors will generally choose the call price rather than the shares of stock during a forced conversion.

55. A “put option” is the right to purchase securities at a predetermined price.

56. A “call option” is the right to purchase securities at a predetermined price.

57. “Futures contracts” can lock in prices, interest rates, and foreign currency exchange rates, compelling

both parties to complete a transaction in accordance with these terms at a later date.

58. A convertible security is almost always

59. A convertible bond is currently selling for $970. It is convertible into 15 shares of common stock that

presently sell for $50 per share. The conversion premium is

60. If the price of common stock associated with a convertible bond is less than the conversion price

61. The conversion ratio is the

62. The conversion premium will be large

63. Which of the following is true?

64. What is the difference between the conversion value and conversion premium?

65. Expectations of a significant increase in the price of a firm’s common stock will result in

66. A convertible bond is currently selling for $1,125. It is convertible into 20 shares of common stock that

presently sell for $40 per share. The conversion premium is

67. A $1,000 par value bond with a conversion price of $50 has a conversion ratio of

68. The theoretical floor value for a convertible bond is its

69. The floor price of a convertible bond cannot fall below

70. The price of a convertible bond

71. The conversion premium is the greatest and the downside risk the smallest when

72. The “floor” or pure bond value of a convertible bond is found by

73. The interest rate on convertibles is generally ____________ the interest rate on similar nonconvertible

instruments.

74. A convertible bond is often utilized

75. A disadvantage to the investor of a convertible bond is that

76. The difference between convertible debt and non-convertible debt is

77. Conversion price is usually set _______ the prevailing market price of the common stock at the time the

bond issue is sold.

78. Which of the following is not a characteristic of convertible bond issues?

79. If the stock price rises substantially above the conversion price, an advantage to the corporation would

be that

80. One advantage to the corporation in selling a convertible bond is

81. Which of the following characteristics are drawbacks of convertible bonds?

82. The principle device used by the corporation to force conversion

83. When a company has a convertible bond in its capital structure,

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84. A step-up in the conversion price refers to

85. The computation of “basic earnings per share” will include consideration of

86. Mirrlees Corp. has $3,000,000 bonds convertible into 50 shares per $1,000 bond. Mirrlees has

1,000,000 outstanding shares. Mirrlees has a tax rate of 40%. The average Aa bond yield at the time of

issue was 10%. Compute the “basic earnings per share” if after-tax earnings are $1,400,000.

87. Mirrlees Corp. has $3,000,000 bonds convertible into 50 shares per $1,000 bond. Mirrlees has

1,000,000 outstanding shares. Mirrlees has a tax rate of 40%. The average Aa bond yield at the time of

issue was 10%. Compute the “diluted earnings per share” if after-tax earnings are $1,400,000.

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88. Vickrey Technology has had net income of $1,500,000 in the current fiscal year. There are 1,000,000

shares of common stock outstanding along with convertible bonds, which have a total face value of $8

million. The $8 million is represented by 5,000 different $1,000 bonds. Each $1,000 bond owes and pays

4% interest. The conversion ratio is 30. The firm is in a 30% tax bracket. What is Vickrey’s “diluted earnings

per share?”

89. Jacobs Company has warrants outstanding, which are selling at a $2.50 premium above intrinsic value.

Each warrant allows its owner to purchase one share of common stock at $26. If the common stock

currently sells for $30, what is the warrant price?

90. Which of the following is true about warrants?

91. The Burma Hat Company‘s warrant is trading for $10.20. The warrant carries the option to purchase

two shares of common stock for $48. What is the speculative premium if the stock price is $51.30?

92. Warrants are

93. The intrinsic value of a warrant to buy four shares of Merton stock at $53 per share is $20. What is the

current market price of Merton stock?

94. Rocky Scholes Swimwear’s warrant is trading for $10.00. The warrant carries the option to purchase a

half share of common stock for $50. What is the speculative premium if the stock price is $65?

95. Sen Corporation warrants carry the right to buy 10 shares of Sen common stock at $11.00 per share.

The common stock has a current market price of $11.75 per share. The intrinsic or minimum value of one

Sen warrant is ________.

96. A warrant that does not expire until several years into the future provides its owner the opportunity to

buy a stock. If the stock price rises, the warrant will probably sell for

97. A contract giving the owner the right to buy or sell an asset at a fixed price for a given period of time is

98. A derivative is a financial instrument whose value is determined by

99. Options contracts are different than futures contracts because

100. The owner of a call has

101. The owner of a put has

102. Which contract is an option?

103. All of the following are advantages to the corporation of issuing convertibles EXCEPT:

104. The following benefits occur to the corporation after a forced conversion of a convertible bond

EXCEPT:

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105. All of the following are motivation for firms to issue warrants EXCEPT:

Chapter 19 Test Bank – Static Summary