Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Chapter 19: Equity and Hybrid Instruments
Multiple Choice Questions
1. Section: 19.1 Shareholders’ Equity
Learning Objective: 19.1
Level of difficulty: Basic
2. Section: 19.2 Preferred Share Characteristics
Learning Objective: 19.3
Level of difficulty: Intermediate
3. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Basic
4. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Intermediate
5. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.2, 19.4
Level of difficulty: Intermediate
6. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Intermediate
7. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Intermediate
8. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Intermediate
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
9. Section: 19.4 Other Hybrids
Learning Objective: 19.5
Level of difficulty: Basic
10. Section: 19.4 Other Hybrids
Learning Objective: 19.5
Level of difficulty: Intermediate
11. Section: 19.4 Other Hybrids
Learning Objective: 19.5
Level of difficulty: Intermediate
Practice Problems
Basic
12. Section: 19.1 Shareholders’ Equity
Learning Objective: 19.1
Level of difficulty: Basic
Solution:
To vote at any meeting of the shareholders of the corporation
13. Section: 19.2 Preferred Shares, 19.3 Warrants and Convertible Securities
Learning Objective: 19.3, 19.4
Level of Difficulty: Basic
Solution:
14. Section: 19.2 Preferred Shares, 19.3 Warrants and Convertible Securities
Learning Objective: 19.2, 19.4
Level of Difficulty: Basic
Solution:
Intermediate
15. Section: 19.2 Preferred Shares
Learning Objective: 19.3
Level of Difficulty: Intermediate
Solution:
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
i. Preferred shares can be a means of raising equity capital without diluting control.
16. Section: 19.1 Shareholders’ Equity
Learning Objective: 19.1
Level of Difficulty: Intermediate
Solution:
a. i. The equity holders will receive the “equity”: $1.7 million less $1.5 million owed to
17. Section: 19.1 Shareholders’ Equity
Learning Objective: 19.1
Level of Difficulty: Intermediate
Solution:
a. You own 500 out of 1 million shares, or 500 / 1,000,000 = 0.05%
18. Section: 19.1 Shareholders’ Equity
Learning Objective: 19.1
Level of Difficulty: Intermediate
Solution:
The founder will own 250,000 shares. The total number of shares outstanding will be 250,000 +
19. Section: 19.1 Shareholders’ Equity, 19.2 Preferred Shares
Learning Objective: 19.1, 19.3
Level of Difficulty: Intermediate
Solution:
As the preferred shares are “cumulative,” all the missed dividends must be paid on them before
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
20. Section: 19.1 Shareholders’ Equity
Learning Objective: 19.2
Level of Difficulty: Intermediate
Solution:
21. Section: 19.2 Preferred Shares, 19.3 Warrants and Convertible Securities
Learning Objective: 19.3, 19.4
Level of Difficulty: Intermediate
Solution:
The conversion value, CV = CR x P (where P = the price of the common stock). From Problem
22. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Intermediate
Solution:
Warrants are usually issued with long-term maturities, while call options have very short-term
23. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Intermediate
Solution:
24. Section: 19.4 Other Hybrids
Learning Objective: 19.5
Level of Difficulty: Intermediate
Solution:
The interest payable is 8% × $30 million (par value) = $2.4 million.
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Challenging
25. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of Difficulty: Challenging
Solution:
Conversion price: CP = Par / CR = $1,000 / 25.32 = $39.49
26. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of difficulty: Challenging
Solution:
27. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of Difficulty: Challenging
Solution:
a. The market value of Orion’s equity is: V = nP = 12,000,000 (shares) x $5 = $60 million
amount you should be willing to pay) for each warrant is $0.64.
28. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Level of Difficulty: Challenging
Solution:
a. We have share price: S= $20, Exercise price of the warrants: X = $18,
c. The minimum value of the warrants:
Share Price (+/– 10%)
Floor Value
%change
$18 (Share price = exercise price)
$0
$20 (Share price now)
0%
$22
100%
28. Section: 19.3 Warrants and Convertible Securities
Learning Objective: 19.4
Level of Difficulty: Challenging
Solution:
With a 4 percent yield, the convertible preferred shares are paying 0.04 x $25 = $1.00 per year in
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Answers to Concept Review Questions
19.1 Shareholders’ Equity
Concept review questions
1. What are the basic rights associated with equity securities? How do these differ across
different categories or classes of equities?
There are three basic rights associated with equity securities: the right to vote, the right to receive
2. Why do voting rights affect the prices of some common shares and not others?
The value of these voting rights very much depends on who has control of the company and
3. Why is dividend income preferred by both corporations and individual investors?
Dividends are very attractive in Canada for tax reasons, both for corporations and for individuals.
19.2 Preferred Shares
Concept review questions
1. Briefly describe the following types of preferred shares: straight, retractable, and floating rate.
Straight preferred shares do not have maturity date and pay a fixed dividend at regular intervals.
Retractable preferred shares give investors the right to sell them back to the issuer, thus creating
an early maturity date. Floating rate preferred share generally have a long maturity date, but
2. Briefly describe the following features that may be associated with preferred shares:
cumulative provision, callable feature, and purchase funds.
Cumulative provision which means that no dividends can be paid on common shares until
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
3. Why are preferred shares sometimes called hybrid securities?
Preferred share many characteristics with debt, for example, they usually have fixed dividend
4. Why would you want a cumulative feature when purchasing preferred shares?
The payoff on shares is not a fixed contractual commitment similar to interest on a bond, so the
19.3 Warrants and Convertible Securities
Concept review questions
1. Explain why issuing debt or preferred shares with warrants attached or issuing convertible
bonds or convertible preferred shares, may represent attractive sources of financing for higher-
risk firms.
When the warrants are exercised, the warrant holder pays the exercise price to the company in
2. Define and explain how to determine the following for a convertible: conversion price,
conversion value, straight bond value, floor value, and convertible premium.
Convertible price is the strike price at which a convertible security can be converted into
19.4 Other Hybrids
Concept review questions
1. Name and discuss the four criteria used by DBRS to classify a security as debt versus equity.
DBRS looks at four major factors to determine whether a security is debt or equity: (1) the
permanence factor, (2) the subordination factor, (3) the legal factor, and (4) the subjective factor.
The permanence factor relates to whether or not the security will be outstanding for a long
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
2. Define the following types of hybrids: income bonds, commodity bonds, real return bonds,
original issue discount bonds, LYONs, ARCs, preferred securities, and COINS.
Income bonds are generally issued after a re-organization, so that the “interest” is tied to some
cash flow level for the firm. Commodity bond is a bond whose interest or principal is tied to the
3. Relate the costs of various financing options to their equity-like characteristics.
The costs of financing options differ according to how much equity weight they have. The more
the weight is, the higher the cost is.