Ch 2 - Preferred Stock

Question 1

Preferred stock characteristics

Answer 1

Form of ownership (equity)
Market prices are influenced by interest rates
Considered a fixed income security

Question 2

Preferred stock settlement

Answer 2

Regular way: T+1
Cash: same day if prior to 2:30pm ET

Question 3

Preferred stock dividends

Answer 3

Must be approved by the BOD
Typically paid on a quarterly basis

Question 4

Preferred stock par value

Answer 4

Also known as face value
Typically $100 for preferred stock
*Could also be $25 or $50
Never fluctuates
Dividend rate based on par

Question 5

Yield

Answer 5

Represents overall rate of return
Based on market price and dividend rate
Continually fluctuates

Yield and market price are inverses
*Low market price = high yield
*High market price = low yield

Question 6

Current yield formula

Answer 6

=annual income
/ market price

Question 7

Fixed income market prices

Answer 7

Discount = trading below par
(indicates interest rate have risen, price down)

Premium = trading above par

Question 8

Rising interest rates,
Fixed income market prices ___________

Answer 8

decline

Question 9

Adjustable-rate preferred stock

Answer 9

Coupon adjusts with interest rates
Coupon benchmarked to T-bill
Market value stays close to par

*no-suitable for people seeking consistent income

Question 10

dividend, interest rate fall
= fixed income securities _______ in price

Answer 10

RISE in price

Question 11

Preferred stock dividends

Answer 11

Must be approved by BOD
Must be paid before common stock dividends

^pref stock holder no voting no pre-emp rights

Question 12

Cumulative preferred stock

Answer 12

Issuer must eventually pay skipped dividends
Beneficial feature for investors
Lower rates of return (vs. straight)

Question 13

Straight (non-cumulative) preferred stock

Answer 13

Issuer does not pay skipped payments
Beneficial feature for the issuer
Higher rates of return (vs. cumulative)

Question 14

Participating preferred stock

Answer 14

Eligible to receive more than the stated dividend rate
Issuers pay more in profitable years
Beneficial feature for the investor
Lower dividend rates (vs. non-participating shares)
Trades at higher prices and lower yields

=higher demand, higher market price, lower yied vs non-part

Question 15

yield > dividend rate

Answer 15

security trading at discount to par

Question 16

Call features

Answer 16

Allows issuer to end an investment by paying back its par value
Calls typically occur when interest rates fall
Beneficial for the issuer
Sold with higher dividend rates (vs. non-callable)
Lower prices & higher yields
Used by issuers to refinance

Question 17

Call protection

Answer 17

Number of years before security can be called
measure time before first possible call

Question 18

Call premium

Answer 18

Amount above par required to call shares

Question 19

Convertible preferred stock

Answer 19

Convertible into common stock of the same issuer
Beneficial feature for investors (higher chance of capital apprec)
Sold with lower dividend rates (vs. non-convertible)
-Higher prices & lower yields

*requires majority approval from shareholders, not required if nonconvertible

Question 20

Conversion ratio

Answer 20

Determines how many common shares received at conversion
Set at issuance and stays fixed

Conversion ratio=Par/Conversion Price

Question 21

Conversion Price

Answer 21

=Par/Conversion Ratio

Price paid per common share if convertible security bought at par

Question 22

Parity price of common stock

Answer 22

Price paid per common share based on convertible security market price

=
Preferred stock market price
_______________________________
Conversion ratio​

Question 23

Parity price of preferred stock

Answer 23

Value of convertible security solely based on the conversion feature

=common stock market price “x” conversion ratio

Question 24

Arbitrage opportunity

Answer 24

Instantaneous profit potential on a security

Question 25

Anti-dilution covenant

Answer 25

Prevents issuer from performing dilution actions without adjusting the conversion feature Involved when stock dividends & splits occur Conversion ratio goes up Conversion price goes down

Question 26

Benefits of preferred stock

Answer 26

Fixed dividend rate provides income Lower tax rates (15% or 20%) Higher income rates than debt securities

Question 27

Corporate dividend exclusion rule

Answer 27

Corporations avoid paying taxes on dividends 50% exemption if owning less than 20% of the issuer’s common stock 65% exemption if owning 20% or more of the issuer’s common stock

Question 28

Participating preferred stock

Answer 28

Eligible to receive more than the stated dividend rate Issuers pay more in profitable years

Question 29

Convertible preferred stock

Answer 29

Convertible into common stock of the same issuer Has capital appreciation potential

Question 30

Preferred stock risks

Answer 30

Dividends are not guaranteed No legal recourse for skipped dividends Subject to: *Interest rate risk *Inflation (purchasing power) risk *Call risk *Reinvestment risk

Question 31

Reinvestment risk

Answer 31

proceeds from an investment (typically dividends or interest) are reinvested back into the market at lower rates of return.

Question 32

interest rate risk

Answer 32

Preferred stock is subject to interest rate risk, which occurs when interest rates rise, resulting in DECLINING market value of fixed income securities If an investor liquidates preferred stock after interest rates rise, it’s quite possible they’ll have a capital loss on the sale (selling the security for less than what it was purchased for). Interest rate risk applies to all forms of preferred stock except adjustable-rate preferred stock (ARPS). When interest rates change, the coupons on ARPS adjust similarly.

Question 33

Preferred stock typical investors

Answer 33

Must seek income as the primary benefit Accepts moderate risk in return for higher income Long-term time horizons Corporate investors (due to tax benefits)