Deck 13: Convertible Securities and Warrants

Question 1

A warrant is an option to buy a bond at a specific price over a given period of time.

Answer 1

False
Explanation: A warrant is an option to buy a stated number of shares of stock from the issuing company at a specified price over a given time period.

Question 2

If a warrant is detachable from its bond, the bond converts upon exercise of the warrant.

Answer 2

False
Explanation: After being separated from the bond, warrants have their own market price and may trade on a different market from the common stock. The bond remains intact.

Question 3

It is normal to issue convertibles and not have their presence reflect dilution until they are converted.

Answer 3

False
Explanation: Accountants now report basic earnings per share and diluted earnings per share. The comparison of basic and diluted earnings per share gives the analyst or investor a measure of the potential effects of these securities.

Question 4

The value of a warrant is the market value of the stock minus the option price of the warrant divided by the number of shares it will buy.

Question 5

The shorter the term to maturity, the higher the conversion premium for the bond.

Question 6

The amount of downside risk cannot vary.

Question 7

With convertible bonds, the bond market price minus the conversion value is the conversion premium.

Question 8

Downside risk is: $\frac {\text { Bond Market Price - Pure Bond Value }} { \text {Conversion Premium } }$

Question 9

Convertible bonds tend to pay better interest rates than straight bonds, since convertibles are of lower risk.

Question 10

A drawback to using convertibles is their dilutive effect.

Question 11

Conversion price is the face value divided by the conversion ratio.

Question 12

Conversion ratio is the face value divided by the conversion price.

Question 13

Floor values are sensitive to interest rates.

Question 14

The conversion feature always causes the bond's price to vary with the stock price.

Question 15

Pure bond value is the conversion price, multiplied by the market price.

Question 16

Conversion value represents the total value of the underlying shares of common stock into which the security may be converted.

Question 17

A convertible bond's price is usually the same as the stock price times the conversion ratio.

Question 18

Companies usually force conversion when conversion values are low.

Question 19

Conversion value is the conversion price multiplied by the conversion ratio.

Question 20

A company usually would not want to issue convertible securities if its stock is undervalued in the market.

Question 21

A company has a convertible bond with a conversion price of $27 per share. The company's common stock is currently trading at $23 per share. What is the conversion value of the bond (rounded to whole dollars)?

A)$1,000
B)$800
C)$852
D)$828

Question 22

Convertible securities are a good investment for conservative investors, for they offer regular income and potential downside protection against falling stock prices.

Question 23

What is the percentage conversion premium of a convertible bond with market value of $900, conversion value of $800, and par value of $1,000?

A)25%
B)20%
C)12.5%
D)10.5%

Question 24

What factor(s) could cause the pure bond value to change?

A)A call provision
B)An increase in stock price
C)A change in market interest rates
D)More than one of the above

Question 25

Convertible securities have been used as a medium of exchange for acquiring other companies' stock in mergers and acquisitions.

Question 26

The premium of warrants tends to decrease as the stock price rises.

Question 27

A warrant with an intrinsic value of zero cannot sell at a premium.

Question 28

Which of the following statements describes the relationship between the market value, pure bond value, and associated stock price related to a convertible bond?

A)Both increase as the common stock price increases
B)Market value approaches the pure bond value as the stock price approaches zero
C)As stock price increases, the pure bond value increases
D)None of the above

Question 29

The leverage associated with a warrant increases as the stock price increases.

Question 30

What is the minimum value on a bond with market value of $900, conversion value of $800, and pure bond value of $650?

A)$900
B)$800
C)$700
D)$650

Question 31

A forced conversion is when the company calls the convertible security knowing the owners will take stock and thus convert debt to equity.

Question 32

Premiums paid for warrants often are related to time.

Question 33

What factor(s) would cause the pure bond value to go up?

A)A decrease in the market interest rate
B)An increase in stock price
C)A change in the conversion ratio
D)More than one of the above

Question 34

What is the conversion ratio of a $1,000 bond convertible at $27 per share? The coupon rate is 10% and the market rate 12%. This company's common stock is currently trading at $23 per share.

A)37.04 shares
B)43.478 shares
C)83 shares
D)35.2 shares

Question 35

What is the percentage downside risk on a bond with market value of $900, conversion value of $800, and pure bond value of $650?

A)66.7%
B)27.7%
C)55.6%
D)None of the above

Question 36

The market price of the bond will not go below the pure bond value regardless of what happens to the price of the common stock.

Question 37

Many warrants are callable.

Question 38

Which of the following statements about a convertible security is not true?

A)It may be either a bond or share of preferred stock
B)It provides level interest payments
C)The best time to buy is when both bond and stock prices are low
D)All of the statements are true

Question 39

Dilution of EPS by warrants is not reflected in computations of earnings.

Question 40

If the stock price is low or declining, the pure bond value is not very important in determining the bond price.

Question 41

From the corporate financial officer's viewpoint, which of the following is not an advantage of issuing convertible bonds?

A)The market value of the firm's common stock may rise dramatically
B)Interest rates are generally lower than on straight debt instruments
C)Conversion may enhance the firm's stock price
D)None of the above are advantages

Question 42

Which of the following is NOT a characteristic of a warrant?

A)It is an option to buy a specified number of shares of stock at a given price over a given period of time
B)It represents a cash inflow to the issuing company when exercised
C)When exercised, it replaces debt on the balance sheet
D)It allows the bond to carry a lower coupon rate

Question 43

From an institutional investor's standpoint, many convertible securities lack liquidity because:

A)of small trading volume.
B)of the small amount of convertibles that are usually issued by one company.
C)of the high premiums that usually come in with buying a convertible.
D)A and B

Question 44

A warrant carries an option to purchase two shares at $35. The warrant's minimum value is determined to be $25. At what price is this company's common stock currently trading?

A)$25.5
B)$50.0
C)$47.5
D)$70.0
E)$95.0

Question 45

A firm has warrants outstanding for investors to purchase 50,000 shares at $25 per share. The current stock price is $40. For accounting purposes, what is the assumed net increase in shares from the exercise of these warrants?

A)18,750
B)50,000
C)31,250
D)None of the above

Question 46

How are warrants used by corporations?

A)To decrease the volatility of their common stock
B)To allow for issuance of debt at rates lower than would otherwise be required
C)To decrease the dilution of earnings per share
D)More than one of the above

Question 47

Warrants are considered to be highly speculative because:

A)they are attached to the bond issue.
B)they have a short life and their value is magnified by movements in the stock price.
C)the intrinsic value is highly volatile.
D)ownership of warrants provides no dividends or interest.

Question 48

As the stock price moves higher, the conversion premium that the investor is willing to pay:

A)becomes higher.
B)stays the same.
C)becomes lower.
D)None of the above

Question 49

Why are warrants less desirable than convertible debentures as financing devices for the creation of new common stock?

A)There is no device for forcing investors to exercise warrants
B)The conversion of convertible securities erases debt on the balance sheet
C)Warrants increase the equity of a firm when exercised, but there is no change in the debt
D)All of the above

Question 50

Generally, the best time to buy convertible bonds is when interest rates are _________ and when stock prices are _______.

A)low; low
B)high; low
C)low; high
D)high; high

Question 51

Which of the following statements explains the premium paid over the intrinsic value of a warrant?

A)The higher the price volatility of the common stock, the greater the premium
B)The market value may fall below the intrinsic value because of the downside risk
C)The greater the time period over which the option may be exercised, the higher the premium
D)More than one of the above are true

Question 52

What variables are needed to calculate diluted earnings per share?

A)Adjusted earnings after taxes, number of shares outstanding, and number of common shares from all potential securities convertible into common stock
B)Adjusted earnings after taxes and number of shares outstanding
C)Adjusted earnings after taxes, shares outstanding, common stock equivalents, and all convertibles
D)Earnings after taxes, common shares outstanding, and all convertible preferred stock

Question 53

Which of the following statements about convertible securities is true?

A)They provide a guaranteed income stream, minimum value, and conversion
B)The conversion premium is influenced by the volatility of the underlying common stock, term to maturity, and dividend payment relative to interest rate
C)They are potentially dilutive to earnings and must be taken into consideration in the calculation of both primary and fully diluted earnings per share
D)All of the above are true

Question 54

What variables are needed to calculate basic earnings per share?

A)Adjusted earnings after taxes, number of shares outstanding, and number of common shares from all potential securities convertible into common stock
B)Earnings after taxes and number of shares outstanding
C)Adjusted earnings after taxes, shares outstanding, common stock equivalents, and all convertibles
D)Earnings after taxes, common shares outstanding, and all convertible preferred stock

Question 55

The more volatile the stock price as measured by beta or standard deviation of returns,

A)the higher the conversion premium.
B)the lower the conversion premium.
C)the higher the interest rate.
D)the lower the interest rate.

Question 56

When warrants are exercised, the company goes through an accounting process to determine the new number of shares created. This process assumes that the company:

A)creates one new share for every warrant exercised.
B)reduces the number of shares created by the amount of shares that can be bought in the market with the proceeds of the cash generated by the exercise of the warrants.
C)creates one new share in the ratio of the exercise price and the current stock price.
D)None of the above

Question 57

From the corporate financial officer's viewpoint, which of the following is a reason for not calling a bond for redemption when the conversion value is above the par value?

A)Calling the bond may encourage everyone to take the stock rather than the par value in cash
B)The after-tax cost of the dividends on the new shares might be higher than the after-tax cost of the interest expense on the existing convertible bond
C)The chief financial officer might want to wait until interest rates decline before calling the bond
D)The number of new shares on the market will cause the diluted earnings per share to decline

Question 58

Corporations may use warrants for which of the following reasons?

A)To issue debt under normal circumstances
B)To use as an 'add-on' in a merger or acquisition agreement
C)To lower the cost of the bonds to the corporation
D)None of the above

Question 59

When is the best time to convert a convertible bond to common stock?

A)When the call price exceeds the conversion value
B)After the conversion ratio decreases
C)When the conversion value is below the pure bond value
D)None of the above

Question 60

A firm has warrants outstanding for investors to purchase 50,000 shares at $25 per share. The current stock price is $40. The firm has l million shares outstanding and earnings per share of $1.50. What are earnings per share when all these warrants are exercised?

A)$1.43
B)$1.47
C)$1.45
D)None of the above

Question 61

Sharpie Cookies has warrants outstanding which allow the holder to purchase 2 shares of stock per warrant at $26 per share. The common stock is currently selling for $28 per share. The warrant has a market value of $6. Calculate the intrinsic value of the warrant and speculative premium.

Question 62

A convertible bond has a face value of $1,000 and the conversion price is $40 per share. The stock is selling at $30 per share. The bond pays $65 per year in interest and is selling in the market for $950. It matures in 7 years. Market rates are 10% annually. (a) What is the conversion ratio?
(b) What is the conversion value?
(c) What is the conversion premium (in dollars and percent)?
(d) What is the floor or pure bond value (using annual analysis)?
(e) Compute the downside risk as a percentage.

Question 63

Assume you bought a convertible bond two years ago for $920. The bond has a conversion ratio of 30. At the time the bond was purchased, the stock was selling at $25 per share. The bond pays $100 in annual interest. The stock pays no cash dividend. Assume after two years the stock price rises to $45, and the firm forces investors to convert to common stock by calling the bond (there is no conversion premium). Would you have been better off if you had bought the stock directly or bought the convertible bond and eventually converted it into common stock? You would have invested $920 in either case.

Question 64

Assume that a firm has warrants outstanding that allow the holder to buy one share of stock at $22 per share. Also assume the stock is selling at $28 per share and warrants are now selling at $10 per warrant. You can invest $1,000 in the stock or the warrants. Assume the stock goes to $44 and the warrants trade at their intrinsic value when the stock is at $44. Would you have a larger total dollar profit by initially investing in the stock or the warrants? Compute the leverage.