An analyst is comparing two bonds, each with a 2-year maturity and a face amount of $100,000. Although both bonds have a yield to maturity of 7.0%, Bond A has a coupon of 6% and Bond B has a coupon of 8%. Assuming that both bonds have annual interest payments, the prices of both Bond A and Bond B are closest to
Answer (B) is correct. The price of the bond is equal to the sum of present value of the face value of the bond and the present value of the interest payments. Thus, the price of Bond A is $98,148 [($100,000 × .873 PV factor) + ($6,000 × 1.808 PV factor)]. The price of Bond B is $101,764 [($100,000 × .873 PV factor) + ($8,000 × 1.808 PV factor)].
If the interest rate on newly issued bonds increases due to expected inflation, which one of the following will most likely occur?
Answer (A) is correct. Higher interest rates on bonds will lead to an increased demand for bond investments, which subsequently decreases the demand for common stock. Also, companies will pay more in interest and will thus have less money for dividends. Both of these factors cause the price of the common stocks to fall.
What variable is measured on the vertical axis of the yield curve?
Answer (B) is correct. The yield curve shows the fluctuations of interest rates (or yield of the bonds) over varying years to maturity. The yield of the bonds is the vertical or y axis.
iWidget Corporation issued convertible bonds with a par value of 1,000. The corporation’s stock is selling at $38.00 per share, and the current market price of the convertible bonds is $1,050. If the conversion ratio is 25, what will be the conversion price?
Answer (C) is correct. The formula for conversion ratio is the par value of the convertible bond divided by the conversion price. Therefore, the conversion price can be calculated as follows: Conversion ratio = Par value of the convertible bond ÷ Conversion price 25 $1,000 ÷ Conversion price Conversion price = $1,000 ÷ 25 = 40
The par value of a common stock represents
Answer (B) is correct. Par value represents a stock’s legal capital. It is an arbitrary value assigned to stock before it is issued. Par value represents a shareholder’s liability ceiling because, as long as the par value has been paid in to the corporation, the shareholders obtain the benefits of limited liability.
In general, it is more expensive for a company to finance with equity capital than with debt capital because
Answer (B) is correct. Providers of equity capital are exposed to more risk than are lenders because the firm is not obligated to pay them a return. Also, in case of liquidation, creditors are paid before equity investors. Thus, equity financing is more expensive than debt because equity investors require a higher return to compensate for the greater risk assumed.
The equity section of Smith Corporation’s Statement of Financial Position is presented below.
Preferred stock, $100 par $12,000,000
Common stock, $5 par 10,000,000
Paid-in capital in excess of par 18,000,000
Retained earnings 9,000,000
Net worth $49,000,000
The common shareholders of Smith Corporation have preemptive rights. If Smith Corporation issues 400,000 additional shares of common stock at $6 per share, a current holder of 20,000 shares of Smith Corporation’s common stock must be given the option to buy
Answer (C) is correct. Common shareholders usually have preemptive rights, which means they have first right to purchase any new issues of stock in proportion to their current ownership percentages. The purpose of a preemptive right is to allow stockholders to maintain their current percentages of ownership. Given that Smith had 2,000,000 shares outstanding ($10,000,000 ÷ $5 par), an investor with 20,000 shares has a 1% ownership. Hence, this investor must be allowed to purchase 4,000 (400,000 shares × 1%) of the additional shares.
Each share of nonparticipating, 8%, cumulative preferred stock in a company that meets its
dividend obligations has all of the following characteristics except
Answer (A) is correct. Dividends on cumulative preferred stock accrue until declared; that is, the book value of the preferred stock increases by the amount of any undeclared dividends. Participating preferred stock participates with common shareholders in excess earnings of the company. In other words, 8% participating preferred stock might pay a dividend each year greater than 8% when the corporation is extremely profitable. Therefore, nonparticipating preferred stock will receive no more than is stated on the face of the stock. Preferred shareholders rarely have voting rights. Voting rights are exchanged for preferences regarding dividends and liquidation of assets.
A financial manager usually prefers to issue preferred stock rather than debt because
Answer (D) is correct. For a financial manager, preferred stock is preferable to debt because dividends do not have to be paid on preferred stock, but failure to pay interest on debt could lead to bankruptcy. Thus, preferred stock is less risky than debt. However, debt has some advantages over preferred stock, the most notable of which is that interest payments are tax deductible. Preferred stock dividends are not.
The following excerpt was taken from a company’s financial statements: “ . . . 10% convertible participating . . . 10,000,000.” What is most likely being referred to?
Answer (D) is correct.
Preferred shareholders have priority over common shareholders in the assets and earnings of the enterprise. If preferred dividends are cumulative, any past preferred dividends must be paid before any common dividends. Preferred stock may also be convertible into common stock, and it may be participating. For example, 10% fully participating preferred stock will receive additional distributions at the same rates as other shareholders if dividends paid to all shareholders exceed 10%.