Foundations of Financial Management, 17e (Block)
Chapter 19 Convertibles, Warrants, and Derivatives
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
semiannual 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 value 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) The downside risk is defined as the difference between the market price and the floor value
of a bond.
16) To calculate the downside risk of a bond in percent, divide the dollar amount by which the
market price could fall (before it reaches the floor value) by the market price.
17) If market rates of interest change, the “floor value” of a convertible bond can change.
18) The floor value of a bond can change if market interest rates for competitive bonds change.
19) Convertible securities are attractive because of their downside protection characteristics, as
well as their upside potential.
20) For the most downside protection, an investor should search for convertibles trading below
par value near their floor value.
21) The downside protection of a convertible bond’s floor value insulates the investor from any
possible loss.
22) Generally speaking, convertible bonds reverse the risk-return trade-off that applies to most
investments.
23) The interest rate on convertible bonds is typically one-third higher than similar non-
convertible issues.
24) 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.
25) The primary issuers of convertible bonds are smaller companies with low credit scores and
high risk, but are growing.
26) In general, the average size of convertible issues is small compared to normal bond issues.
27) On average, convertible bonds have conversion premiums of less than 10% at the time of
issue.
28) A call provision is commonly used by a corporation to force conversion into common stock.
29) 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.
30) A forced conversion will typically alter the corporate balance sheet favorably.
31) Basic earnings per share includes all convertible bonds outstanding.
32) “Basic earnings per share” does not include the dilutive effects of all of a firm’s convertible
bonds.
33) “Diluted earnings per share” must assume the conversion of all convertible securities, even if
they haven’t been converted.
34) In order to calculate basic earnings per share, the earnings after taxes must be adjusted for
the elimination of the convertible bond interest expense.
35) Warrants never sell for more than their intrinsic value.
36) A warrant may carry a speculative premium above intrinsic value if the warrant isn’t going to
expire for a while.
37) Because a warrant is dependent on the market movement of an underlying stock, it is highly
speculative in nature.
38) Warrants are similar to convertible debt in that they give the warrant holder the right to
acquire common stock.
39) Warrants are similar to convertible debt in that they require the issuance of debt in order to
obtain the right to acquire common stock.
40) Warrants are often attached to debt securities to increase the debt issue’s attractiveness to
investors.
41) The premium for a warrant would increase if its underlying common stock has a negative
market outlook.
42) A warrant’s speculative premium equals the market price of the underlying common stock
minus the option price.
43) A warrant is of huge benefit to the warrant holder when the stock rises far above the exercise
price.
44) A warrant is of huge benefit to the company when the stock rises far above the exercise
price.
45) As a financing device for creating common stock, warrants are usually more desirable than
convertible bonds.
46) Warrants are considered in-the-money when the exercise price is above the current market
price.
47) Warrants are considered in the computation of “diluted earnings per share,” but not in “basic
earnings per share.”
48) Theoretically, stock options are granted to employees so that the employees will make
decisions that benefit the owners or shareholders.
49) Most corporations include call provisions in agreements relating to the issue of warrants.
50) Forced conversions of convertible bonds occur when unethical corporate executives call
corporate bonds prematurely.
51) In one stroke through forced conversion, the balance sheet changes, the debt becomes equity,
and the debt disappears. The result is that the debt-to-equity ratio and the debt-to-asset ratio
decline.
52) Convertible bonds and convertible preferred stock are used on a regular basis by corporations
to diversify their capital structure.
53) The conversion value is equal to the conversion ratio times the conversion price.
54) When the market price of a common stock rises above the conversion price, the convertible
bond should always be converted immediately before it drops.
55) The conversion premium of a convertible bond is generally greater when the market price of
the stock is below the conversion price.
56) Convertible bonds offer minimal risk of loss to the investor due to their floor value.
57) Investors will generally choose the call price rather than the shares of stock during a forced
conversion.
58) A “put option” is the right to purchase securities at a predetermined price.
59) A “call option” is the right to purchase securities at a predetermined price.
60) “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.
61) A convertible security is almost always
A) a security that can be converted into any other type of security.
B) a debt security that can only be converted into preferred or common stock.
C) a security that can be converted into common stock at the holder’s option.
D) a security that can be converted into common stock only at the option of the issuing
corporation.
62) 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
A) $90.
B) $220.
C) 57 shares.
D) 13 shares.
63) If the price of common stock associated with a convertible bond is less than the conversion
price
A) the bond will sell at its pure bond value.
B) the bond will sell at its par value.
C) the bond will sell at its conversion value.
D) there is not enough information to tell what the bond price will be.
64) The conversion ratio is the
A) price at which a convertible security is exchanged into common stock.
B) ratio of conversion value to market value of a convertible security.
C) number of shares of common stock that the convertible debt may be converted into.
D) ratio of the conversion premium to market value of a convertible security.
65) The conversion premium will be large
A) if investors have great expectations for the price of the common stock.
B) if interest rates decline.
C) when the conversion value is much greater than the pure bond value.
D) when the stock price is very stable.