Preferred Stock Flashcards
Which statements are TRUE regarding the taxation of dividends received by investors?
I Individuals cannot exclude any dividends received from taxation
II Individuals can exclude 50% of dividends received from taxation
III Corporations cannot exclude any dividends received from taxation
IV Corporations can exclude 50% of dividends received from taxation
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
Corporations that receive dividends from investments held generally are allowed to exclude 50% of the dividends received from taxation. This exclusion does not apply to individual investors (however, individual investors get the benefit of taxation of cash dividends received at a substantially lower rate - 15% (or 20% for those in the highest tax bracket) - than do corporate investors). Thus, a corporation that receives dividends from common stock holdings, preferred stock holdings, or mutual fund holdings where the fund’s income is from common and/or preferred stock investments, is allowed to exclude 50% of that income from taxation.
A customer buys 100 shares preferred at $110 per share. The par value is $100. The dividend rate is 5%. Each dividend payment will be:
A. $250
B. $275
C. $500
D. $550
The best answer is A.
The annual rate is 5% X $100 par value = $5 per share X 100 shares = $500. Since preferred dividends are paid semi-annually, each payment is $250.
A customer buys 100 shares of preferred at $101 per share. The par value is $100. The dividend rate is 8%. Each dividend payment will be:
A. $80
B. $400
C. $800
D. $808
The best answer is B.
The annual rate is 8% X $100 par value = $8 per share X the number of shares = $800. Since preferred dividends are paid semi-annually, each payment would be $400.
Which statements are TRUE about preferred stock?
I When interest rates rise, preferred stock prices rise
II When interest rates rise, preferred stock prices fall
III When interest rates fall, preferred stock prices fall
IV When interest rates fall, preferred stock prices rise
A. I and II
B. I and III
C. II and III
D. II and IV
The best answer is D.
Preferred stock is a fixed income security, and hence, when market interest rates move, the only way for the yield on the security to adjust to the market is to have the price change. When interest rates rise, preferred stock prices fall, increasing the yield on the security; and when interest rates fall, preferred stock prices rise, decreasing the yield on the security.
ABC 8% $100 par preferred is trading at $105 in the market. The current yield is:
A. 6.6%
B. 7.6%
C. 8.6%
D. 10.6%
The best answer is B.
The formula for current yield is:
Annual Income
———————– = Current Yield
Market Price
$8
——– = 7.6 %
$105
ABC Company has issued 8%, $100 par, cumulative preferred stock. Two years ago, ABC paid a 4% preferred dividend. Last year, ABC paid a 5% preferred stock dividend. This year, ABC wishes to pay a common dividend. If the preferred stock is now trading at $94, a customer who owns 100 shares of the company’s preferred stock will receive:
A. $700
B. $800
C. $1,000
D. $1,500
The best answer is D.
Since this is cumulative preferred stock, all missed dividends must be paid before a common dividend can be paid. Two years ago, 4% was missed; last year 3% was missed; and this year’s preferred dividend of 8% must be paid before the common dividend is paid. The total preferred dividend to be paid is 15%.
A customer buys 1,000 shares of ABCD $25 par 8% cumulative preferred stock. This preferred issue pays quarterly dividends. This year, it missed the first 3 quarterly dividends. In the 4th quarter, it paid a common dividend of $.25 per share. In order to do this, it must have paid this preferred shareholder:
A. $400
B. $500
C. $1,600
D. $2,000
The best answer is D.
This customer owns 1,000 shares of $25 par cumulative preferred, for a face value of $25,000. In order to have paid the common dividend,the company must have paid the preferred shareholder the 3 missed quarterly dividends in addition to the current quarterly dividend. Therefore, it must pay the annual dividend amount of 8% of $25,000 = $2,000 to this preferred shareholder.
ABC Company has outstanding 6% cumulative preferred stock. Two years ago, ABC paid a 6% preferred dividend. Last year, ABC paid a 4% preferred stock dividend. This year, ABC wishes to pay a common dividend. The preferred shareholders must receive:
A. 0%
B. 2%
C. 6%
D. 8%
The best answer is D.
On cumulative preferred stock, all back unpaid dividends PLUS this year’s preferred dividend must be paid before a common dividend is paid. Thus, 2 years ago the full 6% preferred dividend was paid, so there is no arrearage; last year only 4% was paid, so 2% was missed. Before a common dividend can be paid this year, the missing 2% plus this year’s 6% preferred dividend, or a total of 8% must be paid.
Which security of the same issuer is likely to give the highest current yield?
A. warrant
B. common stock
C. convertible preferred stock
D. non-convertible preferred stock
The best answer is D.
Warrants give no yield. Common stocks give the lowest yields since there is direct growth potential in the price of the stock as reported earnings increase. Convertible preferred yields are higher than common yields but not as high as non-convertible yields. A non-convertible preferred stockholder gets a fixed rate of return without any growth potential. A convertible preferred stockholder can convert to common if the common’s price rises, so growth potential is included. Because of this, yields for convertible preferred are lower than for non-convertible preferred.
Which of the following statements are TRUE when comparing convertible preferred stock and non-convertible preferred stock?
I Convertible preferred issues will have a higher yield than similar non-convertible yields of the same issuer
II Non-convertible preferred issues will have a higher yield than similar convertible yields of the same issuer
III Convertible preferred stockholders can benefit as the common stock price rises
IV Non-convertible preferred stockholders can benefit as the common stock price rises
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
Non-convertible preferred yields are higher than convertible yields. A non-convertible preferred stockholder gets a fixed rate of return without any growth potential. A convertible preferred stockholder can convert to common if the common’s price rises, so growth potential is included. Because of this, yields for convertible preferred are lower than for non-convertible preferred.
A corporation issues $100 par convertible preferred stock, convertible at $20 per share, when the market price of the common is currently $10. Which statement is TRUE?
A. The conversion ratio is 10:1
B. The conversion ratio is 5:1
C. The conversion ratio is 2.5:1
D. The conversion ratio is 2:1
The best answer is B.
The conversion ratio is Par Value / Conversion Price.
$100 Par / $20 Conversion Price = 5:1 Conversion Ratio.
A corporation issues $50 par convertible preferred stock, convertible at $20 per share, when the market price of the common is currently $10. Which statement is TRUE?
A. The conversion ratio is 10:1
B. The conversion ratio is 5:1
C. The conversion ratio is 2.5:1
D. The conversion ratio is 2:1
The best answer is C.
The conversion ratio is Par Value / Conversion Price.
$50 Par / $20 Conversion Price = 2.5:1 Conversion Ratio.
If a corporation with outstanding callable convertible preferred stock, calls these shares in a “forced conversion” which of the following will happen?
I The number of common shares outstanding will increase
II The number of common shares outstanding will decrease
III Earnings per share will decrease
IV Earnings per share will increase
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
In a “forced conversion,” a corporation calls outstanding preferred stock or bonds that are trading at a price well above par, typically with no call premium (or a very small call premium). The better choice for the preferred shareholder is to convert into common, since the equivalent number of shares of common are worth more than the price at which the securities will be called. Thus, this forces the senior security holder to convert. When conversion occurs, the number of common shares increases, and hence, earnings per common share decreases.
A corporation has issued $100 par, 8% cumulative convertible preferred stock, callable at par. The preferred is convertible into 1.4 shares of common stock. Currently, the preferred stock is trading at $102 while the common stock is trading at $75.50. The corporation calls the preferred stock at par plus accrued dividends of $2 per share. The corporation is making a(n):
A. tender offer
B. forced conversion
C. advance refunding
D. simultaneous transaction
The best answer is B.
If a preferred stockholder converts and sells the stock in the market, he realizes the equivalent of 1.4 (conversion ratio) x $75.50 current market price = $105.70 per share. If he or she tenders the preferred on the call, he or she receives $100 per share. He or she will not continue to hold the preferred since dividend payments will cease. The best choice for the preferred shareholder is to convert. In effect, the corporation is forcing the shareholders to convert to common.
A corporation has issued $100 par, 4% cumulative convertible preferred stock, callable at par. The preferred is convertible into 4 shares of common stock. Currently, the preferred stock is trading at $103 while the common stock is trading at $26. If a customer buys 100 preferred shares, converts, and then sells the common stock in the market, the profit or loss is (ignoring commissions):
A. $100 gain
B. $100 loss
C. $7,400 gain
D. $7,400 loss
The best answer is A.
If the customer buys 100 shares of the preferred stock, he or she will pay 100 x $103 per share = $10,300. Since each share of preferred is convertible into 4 common shares, the 100 preferred shares will be converted into 4 x 100 = 400 common shares. The sale of 400 common shares at the current market price of $26 will yield $10,400. The net gain is: $10,400 - $10,300 = $100.
A corporation issues $100 par convertible preferred stock, convertible at $10 per share, when the market price of the common is currently $5. The preferred is issued under an “anti-dilutive covenant.” If the company declares a 25% stock dividend, which statements are TRUE?
I The conversion price remains at $10
II The conversion price is adjusted to $8
III The conversion ratio remains at 10:1
IV The conversion ratio is adjusted to 12.5:1
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is D.
Under an “anti-dilutive” covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $10 per share. If there is a 25% stock dividend, the new conversion price will be adjusted to $10/1.25 = $8 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/$8 = 12.5.
A corporation issues $100 par convertible preferred stock, convertible at $8 per share when the market price of the common is $4. The preferred is issued under an “anti-dilutive covenant.” If the company declares a 2:1 stock split, which statements are TRUE?
I The conversion price is adjusted to $2
II The conversion price is adjusted to $4
III The conversion ratio is adjusted to 25:1
IV The conversion ratio is adjusted to 50:1
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
Under an “anti-dilutive” covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $8 per share. If there is a 2 for 1 stock split, the new conversion price will be adjusted to $8/2 = $4 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/4 = 25:1.
ABC Corp. has a convertible preferred issue with an “anti-dilutive” covenant. ABC declares a stock dividend. After the stock dividend is paid, which statements are TRUE?
I The conversion price is decreased
II The conversion price is unaffected
III The conversion ratio is increased
IV The conversion ratio is unaffected
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
When a senior convertible security is issued with an “anti-dilutive” covenant, should the company issue additional common shares, the terms of conversion are adjusted. Additional common shares will be issued, and since there are more common shares now outstanding, each share will be worth proportionately less. To adjust the terms of conversion, the conversion price is reduced, and the number of common shares into which the security is convertible (the conversion ratio) is increased.
A corporation issues $100 par convertible preferred stock, convertible at $50 per share when the market price of the common is $30. The preferred is issued under an “anti-dilutive covenant.” If the company declares a 25% stock dividend, which statements are TRUE?
I The conversion price is adjusted to $40
II The conversion price is adjusted to $62.50
III The conversion ratio is adjusted to 2.5:1
IV The conversion ratio is adjusted to 1.6:1
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
Under an “anti-dilutive” covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $50 per share. If there is a 25% stock dividend, the new conversion price will be adjusted to $50/1.25 = $40 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/$40 = 2.5:1.
Preferred stock is issued with an “anti-dilutive” covenant. If the corporation declares a 5% stock dividend, which statements are TRUE?
I The conversion ratio is increased
II The conversion price is increased
III The conversion ratio is decreased
IV The conversion price is decreased
A. I and II
B. I and IV
C. II and III
D. III and IV
The best answer is B.
When a senior convertible security is issued with an “anti-dilutive” covenant, should the company issue additional common shares, the terms of conversion are adjusted. When additional common shares are issued, there are more common shares outstanding, with each share being worth proportionately less. To adjust the terms of conversion, the conversion price is reduced, and the number of common shares into which the security is convertible (the conversion ratio) is increased.
If interest rates fall, issuers most likely will call:
I low dividend rate preferred issues
II high dividend rate preferred issues
III preferred issues trading at a premium
IV preferred issues trading at a discount
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
If interest rates fall, issuers most likely will “call in” old high rate preferred and replace it by selling new preferred at the lower current rates. High rate preferred will sell at a premium if market interest rates are dropping.
Which statement is BEST regarding participating preferred stock?
A. The dividend rate is fixed
B. The dividend rate varies depending on the decision of the Board of Directors
C. The dividend rate is fixed as to maximum but not as to minimum
D. The dividend rate is fixed as to minimum but not as to maximum
The best answer is D.
Participating preferred pays a fixed dividend rate but also participates with common in “extra” dividends declared by the Board of Directors. Therefore, the dividend rate is fixed as to minimum but not as to maximum.
During a period of stable interest rates, which type of preferred stock would show the greatest price volatility?
A. Cumulative
B. Adjustable rate
C. Participating
D. Callable
The best answer is C.
Preferred stock is interest rate sensitive, since it is a fixed income security. As market interest rates rise, preferred stock prices fall. As market interest rates fall, preferred stock prices rise. If market interest rates are stable, preferred stock prices should be stable as well. However, participating preferred stock gives the preferred participation in any “extra” dividends declared by the company to its common shareholders. Thus, the declaration of such an extra dividend would make the preferred stock more valuable and its price would go up in the market - and this did not happen because market interest rates fell.
Almost all preferred stock is cumulative - any unpaid dividends accumulate and must be paid before a common dividend can be paid.
A call provision can suppress the price of preferred from rising as market interest rates drop, since it is likely that the issuer will call in the preferred and issue new stock at lower current rates. However, during a period of stable interest rates, the call provision has no impact of the preferred stock’s price.
Adjustable rate preferred moves the dividend rate up or down as market interest rates move up or down. With any variable rate security, the dividend or interest rate moves and the price stays right at par. Furthermore, when interest rates are stable, the dividend rate will not adjust and the price will be stable as well.
Which of the following are terms associated with preferred stock?
I Convertible
II Callable
III Cumulative
IV Redeemable
A. I and II
B. III and IV
C. I, II, III
D. I, II, III, IV
The best answer is C.
Preferred stock is not a redeemable security - it is a negotiable security. The stock cannot be redeemed with the issuer - an investor who wishes to liquidate must sell the stock in the market. Preferred stock can be callable, cumulative, and convertible.
