FIN 540 WEEK 3 CHAPTER 20

FIN 540 WEEK 3 1. Which of the following statements is most CORRECT?
a. By law in most states all preferred stock must be cumulative meaning that the
compounded total of all unpaid preferred dividends must be paid before any dividends
can be paid on the firm's common stock.
b. From the issuer's point of view, preferred stock is less risky than bonds.
c. Whereas common stock has an indefinite life, preferred stocks always have a specific
maturity date, generally 25 years or less.
d. Unlike bonds, preferred stock cannot have a convertible feature.
e. Preferred stock generally has a higher component cost of capital to the firm than does
common stock.
2. Which of the following statements about convertibles is most CORRECT?
a. One advantage of convertibles over warrants is that the issuer receives additional cash
money when convertibles are converted.
b. Investors are willing to accept a lower interest rate on a convertible than on otherwise
similar straight debt because convertibles are less risky than straight debt.
c. At the time it is issued, a convertible's conversion (or exercise) price is generally set
equal to or below the underlying stock's price.
d. For equilibrium to exist, the expected return on a convertible bond must normally be
between the expected return on the firm's otherwise similar straight debt and the
expected return on its common stock.
e. The coupon interest rate on a firm's convertibles is generally set higher than the market
yield on its otherwise similar straight debt.
3. Which of the following statements concerning warrants is correct?
a. Warrants are long-term put options that have value because holders can sell the firm's
common stock at the exercise price regardless of how low the market price drops.
b. Warrants are long-term call options that have value because holders can buy the firm's
common stock at the exercise price regardless of how high the stock's price has risen.
c. A firm's investors would generally prefer to see it issue bonds with warrants than straight
bonds because the warrants dilute the value of new shareholders, and that value is
transferred to existing shareholders.
d. A drawback to using warrants is that if the firm is very successful, investors will be less
likely to exercise the warrants, and this will deprive the firm of receiving any new capital.
e. Bonds with warrants and convertible bonds both have option features that their holders
can exercise if the underlying stock's price increases. However, if the option is exercised,
the issuing company's debt declines if warrants were used but remains the same if it
used convertibles.
FIN 540 - Homework Chapter 20
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FIN 540 Homework Chapter 20
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4. Which of the following statements is most CORRECT?
a. One important difference between warrants and convertibles is that convertibles bring in
additional funds when they are converted, but exercising warrants does not bring in any
additional funds.
b. The coupon rate on convertible debt is normally set below the coupon rate that would be
set on otherwise similar straight debt even though investing in convertibles is more risky
than investing in straight debt.
c. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to
buy a risky, volatile stock, other things held constant.
d. Warrants can sometimes be detached and traded separately from the debt with which
they were issued, but this is unusual.
e. Warrants have an option feature but convertibles do not.
5. Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment
bankers also stated that the company can sell an issue of annual payment preferred stock to
corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax
return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would
represent an after-tax risk premium. What coupon rate must be set on the preferred in order to
issue it at par?
a. 6.66%
b. 6.99%
c. 7.34%
d. 7.71%
e. 8.09%