Finance Chapter 16 Problems Given The Information Below Answer The

Chapter 16 Convertible Bonds and Convertible Preferred Stock

TRUE/FALSE

option into common stock.

other debt.

convertible bond falls.

the stock into which the bond may be converted.

shares, the exercise (conversion) price is $40 a share.

comparable non-convertible bonds.

sets a floor (i.e., the minimum price) for the bond.

value as stock.

convertible bond will be called increases.

convertible bond will be called declines.

convert the bond or lose the appreciation achieved by the

stock.

as debt increases.

debt tends to decline as the price of the stock rises.

stock tends to fall as the price of the stock rises.

tend to be less than the potential capital gains on the stock

into which the bond may be converted.

advantage to the stock, the less attractive is a convertible

bond.

investors than the firm’s convertible bonds.

feature designed to force conversion.

treated as a tax-deductible expense to the firm.

convertible preferred stock will also tend to fall.

to the issuer (i.e., redeem the bond) at par prior to

maturity.

the option in a put bond.

tend to fluctuate more than a bond without the put option.

the firm at par is more speculative than buying a bond that

lacks this feature.

lack the put feature.

MULTIPLE CHOICE

a. an indenture

b. a call feature

c. a strong sinking fund

d. a maturity date

1. market price

2. value as stock

3. value as debt

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. 1, 2, and 3

1. current rate of interest

2. number of shares into which it is convertible

3. price of the stock

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. 1, 2, and 3

1. greater than its value as stock

2. less than its value as stock

3. greater than its value as debt

4. less than its value as debt

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

a. protect stockholders from early conversions

b. protect bondholders from conversions by stockholders

c. force stockholders to convert

d. force bondholders to convert

a. the value of convertible bonds and convertible

preferred stock declines

b. the value of convertible bonds falls but

convertible preferred stock rises

c. the value of convertible bonds rises but

convertible preferred stock falls

d. the value of convertible bonds and convertible

preferred stock rises

depend on

a. the bond’s coupon

b. the conversion price of the bond

c. current interest rates

d. the term of the bond

1. interest rates rise

2. interest rates fall

3. the price of the stock rises

4. the price of the stock falls

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

a. the investor to convert the bond into stock

b. the firm to call the bond

c. the investor to sell the bond back to the company

d. the firm to pay a variable rate of interest

1. interest ceases to accrue

2. the bondholder receives the principal

3. the bondholder generally converts the bond

4. dividends are paid to the bondholder

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

equity because

a. the bonds require interest payments

b. the bonds are callable

c. dividends to bondholders reduce earnings

d. new shares are issued when the bonds are converted

1. pays a fixed dividend

2. pays a variable dividend

3. may be converted into the firm’s bonds

4. may be converted into the firm’s stock

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

1. the exercise (i.e., conversion) price

2. the number of shares into which the stock may

be converted

3. the price of the common stock

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

of the following strategies would be best?

a. sell the stock short

b. buy a convertible bond and short the stock

c. buy the stock

d. buy the firm’s convertible securities

1. to exceed the firm’s common stock dividends

2. to be less than the firm’s common stock dividends

3. over time to offset the premium paid for the bond

4. to increase the premium paid for the bond

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

1. increases as the bond‘s coupon increases

2. decreases as the bond‘s coupon increases

3. increases as the stock’s dividend increases

4. decreases as the stock’s dividend increases

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

PROBLEMS

1. Given the information below, answer the following

questions.

A convertible bond has the following features:

Principal $1,000

Maturity date 20 years

Interest $80 (8% coupon)

Call price $1,050

Exercise price $65 a share

a. The bond may be converted into how many shares?

b. If comparable non-convertible debt offered an annual yield

of 12 percent, what would be the value of this bond as debt?

c. If the stock were selling for $52, what is the value of

the bond in terms of stock?

d. Would you expect the bond to sell for its value as debt

(i.e., the value determined in b) if the price of the stock

were $52?

e. If the price of the bond were $960, what are the premiums

paid over the bond‘s value as stock and its value as debt?

f. If the price of the stock were $35, what would be the

minimum price of the bond?

g. What is the probability that the bond will be called when

the price of the stock is $52?

h. If the price of the stock rose to $73, what would happen

to the price of the bond?

i. If the price of the stock were $73, what would the

investor receive if the bond were called?

j. What will the investor receive when the bond matures?

2. A $50 par value convertible preferred stock is convertible

into 5 shares (exercise price of $10). The preferred is

selling for $75, and the price of the common stock is $12.If

the price of the common stock rises to $20, what is the

minimum percentage price increase the holder of the preferred

stock should experience?

3. Corporation HBM has a convertible bond with the following

terms:

coupon 5%

principal $1,000

maturity 10 years

conversion price $50 (20 shares)

call price $1,000 + one year’s interest

The bond‘s credit rating is BBB, and comparable BBB rated

bonds yield 9 percent.

The firm‘s stock is selling for $45 and pays a dividend of

$1.50 a share. The convertible bond is selling for $1,000.

a. What is the premium paid over the bond’s value as stock?

b. Given the bond’s income advantage, how long must the

investor hold the bond to overcome the premium over the

bond‘s value as stock?

c. If the price of the bond stock to $65, is there any reason

to expect the firm to call the bond?

d. If the convertible bond is held to maturity, what is the

annualized return on an investment in the bond?

e. If the price of the stock declines to $25 a share while

interest rates on BBB rated bonds rise to 12 percent, what

impact does the increase in interest rates have on this

convertible bond?

4. A firm has both a convertible bond and a convertible

preferred stock outstanding. The convertible bond has the

following features:

Coupon 6.5%

Maturity date 10 years

Exercise price $20

Principal $1,000

Call price $1,065.

The convertible preferred stock has the following features:

Annual dividend $2.25

Convertible into 2.5 shares of common stock

Callable at $25 a share.

Currently the common stock is selling for $13; the yield on

non-convertible bonds is 10%, and the yield on comparable

preferred stocks is 14%. What is the value of the above

securities in terms of the common stock? What would be the

value of each security if it lacked the conversion feature?

SOLUTIONS TO THE PROBLEMS