Deck 20: Financing With Derivatives

Question 1

A warrant has an exercise price of $15. The underlying common stock has a market price of $10. The formula value of a warrant would be

A) $5
B) $0
C) -$5
D) cannot be determined from the information given

Answer 1

B

Question 2

All other things being equal, the ____ the exercise price, given the stock price, the ____ is the call option value.

A) higher, higher
B) higher, lower
C) lower, lower
D) lower, higher

Answer 2

B

Question 3

The conversion value (i.e., stock value) of a convertible bond is defined as the ____ times the ____.

A) conversion ratio, conversion price
B) conversion premium, exercise price
C) conversion ratio, common stock market price
D) conversion ratio, exercise price

Answer 3

C

Question 4

A ____ is a fixed income security with a call option on common stock.

A) convertible security
B) warrant
C) futures contract
D) derivative security

Question 5

The conversion ratio of a convertible security may change when

A) a cash dividend is paid
B) there is a change in the market value of the security
C) a stock dividend is paid
D) there is a rights offering

Question 6

The difference between the market value of a convertible bond and the higher of its conversion or straight-bond value is the

A) exercise premium
B) investment premium
C) conversion premium
D) liquidation premium

Question 7

The market value of a convertible debt issue is usually above the

A) conversion ratio
B) conversion value
C) straight-bond value
D) higher of either the conversion value or the straight-bond value

Question 8

Which of the following (if any) are factors affecting the value of a call option?

A) time remaining until expiration date
B) interest rates
C) expected stock price volatility
D) all of these factors affect the value of a call option

Question 9

The ____ the expected stock price volatility, the ____ the value of the call option.

A) greater, higher
B) lower, higher
C) greater, lower
D) lower, lower

Question 10

Which of the following is not a common feature of financing with warrants?

A) an exercise price that is below the market price of common stock at the time the warrant is issued
B) typical life of a warrant is between 5 and 10 years
C) warrant is usually detachable from a debenture or preferred stock
D) if a warrant is issued as part of a "unit,"it is usually detachable from a debenture or preferred stock

Question 11

____ are forms of options.

A) Warrants
B) Convertible securities
C) Leases
D) Warrants and convertible securities

Question 12

Conversion of a convertible security may be forced by the issuing company by

A) raising the interest rate
B) calling the securities for redemption
C) lowering the dividend on common stock
D) none of these are methods of forcing conversion

Question 13

A(n) ____ is a call option issued by a company on its securities, usually common stock.

A) debenture
B) warrant
C) futures contract
D) extendible note

Question 14

The conversion premium of a convertible bond tends to be ____ when the conversion value is ____ the straight-bond value.

A) smallest, nearly equal to
B) largest, less than
C) largest, greater than
D) largest, nearly equal to

Question 15

The ____ is the price that the call option buyer pays the writer of the option if the buyer decides to exercise the option.

A) option premium
B) option discount
C) conversion price
D) exercise price

Question 16

The ____ the time remaining before an option expires, the ____ the option value.

A) longer, lower
B) shorter, higher
C) longer, higher
D) shorter, lower

Question 17

As a financing device, warrants have been used in connection with

A) bond swaps
B) equity offerings
C) debt restructurings and bond swaps
D) bond swaps, equity offerings, and debt restructurings

Question 18

The price at which convertible securities are exchangeable for common stock is the

A) conversion value
B) par value
C) put price
D) conversion price

Question 19

All of the following are reasons why companies issue convertible securities except:

A) cheaper total cost than nonconvertible securities
B) lower interest payments than nonconvertible securities
C) sell common stock at a price above current market price
D) deferred issuance of common stock

Question 20

When a company issues convertible securities, its usual intention is:

A) future issuance of common stock
B) future reduction of outstanding common stock
C) future issuance of non-convertible debt and preferred stock
D) future issuance of preferred stock

Question 21

The Marsh Company, whose present balance sheet is summarized below, is considering the issuance of $50 million of 8% subordinated debentures that are convertible into common stock at a price of $20.
Determine the amount of long-term debt (LTD) and common equity (CE) on the pro forma balance sheet, assuming conversion of the entire issue (Answers are in $ million).

A) LTD $150, CE $250
B) LTD $150, CE $300
C) LTD $200, CE $300
D) LTD $200, CE $250

Question 22

The similarities between convertible securities and warrants include all of the following except:

A) both tend to reduce agency costs
B) the purpose of both is the deferred issuance of common stock
C) both give the company full control over when the common stock is issued
D) all of these answers are correct

Question 23

The preemptive right allows shareholders the

A) opportunity to maintain their original ownership percentage
B) right to purchase shares in the secondary markets
C) right to vote for members of the board of directors
D) all of these answers are correct

Question 24

Prior to a warrant's expiration, its market price will be ____ the formula value

A) equal to
B) less than
C) greater than
D) negative as compared to

Question 25

A type of financial derivative that would allow a firm to hedge against changes in interest rates over a 5-year period is a ____.

A) interest rate futures contract
B) commodity soup
C) interest rate swap
D) interest rate put option

Question 26

A ____ is a fixed-income security issued by a company with a call option on its common stock.

A) warrant
B) convertible debenture
C) lease
D) extendible note

Question 27

In general, the market price of a "right" is ____ than the theoretical value and this difference in values ____ as the right's expiration date approaches.

A) less, decreases
B) less, increases
C) greater, decreases
D) greater, increases

Question 28

____ are examples of contingent claims.

A) Convertible bonds and warrants
B) Warrants and extendible notes
C) Options and extendible notes
D) Convertible bonds, options, and warrants

Question 29

Rizzo Company has debentures ($1,000 par) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature in 12 years. In addition, the convertible debenture is callable at 110% of the par value. Straight debt of equivalent risk is yielding 12%. The company's common stock is selling at $22 per share. The company has a marginal tax rate of 40%. Determine the conversion value of the issue.

A) $1,000
B) $ 880
C) $1,136
D) $1,120

Question 30

If the exercise price of an M-tel warrant is $48 and the stock splits 2 for 1, what will be the post-split exercise price of the warrant? Assume the warrant was selling for $20 before the stock split.

A) $24
B) $20
C) $10
D) $48

Question 31

A security whose payoffs (returns) depend on the value of another security is known as a(n) ____.

A) interest rate swap
B) master limited partnership
C) contingent claim
D) extendible note

Question 32

Bonds may have a ____ which gives the holder of the bond the right to sell it back to the issuer under certain conditions.

A) warrant
B) put option
C) rights offering
D) call option

Question 33

Craig Supermarkets, Inc. has convertible debentures ($1,000 par value) that are callable at 108 percent of par value. The conversion price of the debenture is $40 per share, and the Craig common stock currently is selling at $55 a share. The company

A) could not get the convertible holders to convert if it called the debt
B) has no intention of calling the convertibles
C) could force conversion by calling the issue
D) could realize a gain of $15 a share if it called the convertibles

Question 34

Rizzo Company has debentures ($1,000 par) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature in 12 years. In addition, the convertible debenture is callable at 110% of the par value. Straight debt of equivalent risk is yielding 12%. The company's common stock is selling at $22 per share. The company has a marginal tax rate of 40%. Determine the straight-bond value of the issue.

A) $1,000
B) $ 496
C) $ 880
D) $ 753

Question 35

____ earnings per share are calculated based on the assumption that all dilutive securities are converted into common shares.

A) Primary
B) Full primary
C) Fully diluted
D) First class

Question 36

All of the following are reasons why firms issue warrants except:

A) lowers agency costs
B) increases leverage at time of issue
C) permits a company to sell common stock at a price above the price prevailing at the time of warrant issue
D) allows a firm to sell common stock in the future without incurring underwriting costs at the time of sale

Question 37

Which of the following securities (if any) is not an example of an option?

A) warrant
B) convertible security
C) right
D) futures contract

Question 38

The most basic type of interest rate swap is the:

A) fixed for floating rate swap
B) exchange-rated swap
C) LIBOR for prime rate swap
D) Interest rate rights offering

Question 39

The conversion price of CRX's convertible ($1000 par) subordinated debentures is $40 and the present market price of CRX common stock is $48. Determine the present conversion value of the convertible issue.

A) $1,000
B) $1,200
C) $ 833
D) $1,680

Question 40

A firm that issues warrants

A) can expect to receive additional funds if the formula value of the warrant is zero at the expiration date
B) has to pay the same per share dividend to the warrant holders as it pays to its stockholders
C) cannot issue convertible securities while the warrants are outstanding
D) can expect to receive additional funds if the formula value of the warrant is positive at the expiration date

Question 41

The Ogden Company has warrants outstanding that entitle the holder to purchase 4 shares of the company's common stock at an exercise price of $20 per share. The market price of the warrants is $30 and the common stock price is $25. Determine the premium over the formula value that the warrants are selling for.

A) $20
B) $25
C) $10
D) $30

Question 42

Mills Trucking, Inc. has debentures ($1,000 par value) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature 20 years from today. Straight debt of equivalent risk is yielding 10% today. The company's common stock today is selling at $23 a share. Calculate the straight-bond value of the issue.

A) about $830
B) about $1,000
C) about $950
D) about $1,500

Question 43

Graybar recently sold a convertible bond with a $1,000 par value for a flotation cost of 2 percent (each bond produced $980 for the firm). What is the conversion price if the conversion ratio is 22?

A) $44.55
B) $45.45
C) $50.00
D) $4.45

Question 44

JDH, Inc. presently has warrants outstanding that expire 5 years from today. Each warrant entitles the holder to purchase 2 shares of the company's common stock at an exercise price of $30 a share. The warrants currently are trading at $4 each, and the JDH common stock currently is trading at $28 a share. Calculate the warrants' formula value.

A) -$4.00
B) -$2.00
C) $0.00
D) $2.00

Question 45

The Coatesville Company has decided to sell additional common stock through a rights offering. The company has 12 million shares outstanding and plans to sell an additional 1.5 million shares through a rights offering. Each shareholder will receive one right for each share currently held, and thus each right will entitle shareholders to purchase 0.125 shares. The Coatesville common stock is currently selling at $50 per share, and the subscription price of the rights will be $45 per share. Determine the theoretical value of the right for the rights on case.

A) $0.556
B) $0.455
C) $0.50
D) $0.625

Question 46

Mercury Inc. issued bonds with warrants attached that had an exercise price of $22. Each warrant allows the holder to purchase two shares. Since the issuance, the stock split 2 for 1, the current stock price is $24 and the warrant price is $30. How much is the warrant selling above its formula value?

A) 84.6%
B) 130.8%
C) 15.4%
D) 269%

Question 47

The capital structure of Springmaid Company is as follows:
The company has decided to raise additional capital by selling $100 million of 8% debentures with warrants attached. Each $1000 debenture will have 40 warrants attached, and each warrant will entitle the holder to purchase one share of common stock at $20. Assume that no other changes in the capital structure occur between now and the time the warrants are exercised. Determine the common stock at par account balance after exercise of the warrants.

A) $50 million
B) $54 million
C) $56 million
D) $35 million

Question 48

The capital structure of Springmaid Company is as follows:
The company has decided to raise additional capital by selling $100 million of 8% debentures with warrants attached. Each $1000 debenture will have 40 warrants attached, and each warrant will entitle the holder to purchase one share of common stock at $20. Assume that no other changes in the capital structure occur between now and the time the warrants are exercised. Determine how much total capital the company will raise as a result of the issuance of debentures with warrants attached (after exercise of the warrants).

A) $100 million
B) $ 80 million
C) $180 million
D) $20 million

Question 49

The Coatesville Company has decided to sell additional common stock through a rights offering. The company has 12 million shares outstanding and plans to sell an additional 1.5 million shares through a rights offering. Each shareholder will receive one right for each share currently held, and thus each right will entitle shareholders to purchase 0.125 shares. The Coatesville common stock is currently selling at $50 per share, and the subscription price of the rights will be $45 per share. Determine the theoretical value of the rights for the ex rights case.

A) $0.455
B) $0.50
C) $0.625
D) $0.556

Question 50

Sharp Innovations has warrants outstanding and each entitles the holder to purchase 1 share of common stock at an exercise price of $14 a share. If the current market price of the warrant is $9 and the common stock price is $22, what is the premium over the formula value for the warrants?

A) $1
B) $5
C) $8
D) $2

Question 51

A Sorsi bond has a par value of $1,000 but is currently selling for $920. If the bond has a conversion ratio of 23 what is the conversion price? Current stock price is $30.

A) $40.00
B) $43.48
C) $33.33
D) $30.67

Question 52

People Southwest Airlines (PSW) has warrants outstanding that have an exercise price of $10. Each warrant entitles the holder to purchase one share of PSW common stock. Last week PSW common stock was selling for $12 per share and, at the same time, the warrants traded at $5 each. Determine the formula value of PSW warrants.

A) $0
B) $2
C) $5
D) $11

Question 53

To raise capital funds, Twixt, Inc. issued $2 million worth of debentures with warrants attached. The warrants had an exercise price of $15 and each warrant entitled the holder to two shares of common stock. If the current market price per share of Twixt is $20, what is the formula value of a Twixt warrant?

A) $10
B) $ 5
C) $20
D) $ 0

Question 54

A debenture of the Allegro Company (par value $1,000) is convertible into the company's common stock at a price of $50 per share. The convertible bond has a coupon interest rate of 7% and matures in 10 years. Straight debt of equivalent risk and maturity is yielding 8%. The company's common stock is currently selling for $60 per share. Determine the conversion value and straight-bond value of Allegro Company's convertible bonds.

A) $1,200; $1,000
B) $1,000; $933
C) $1,200; $933
D) $1,000; $1,000

Question 55

The Bates Company has debentures ($1,000 par value) outstanding that are convertible into the company's common stock at a price of $50. The convertibles have a coupon interest rate of 9% and mature 20 years from today. Straight debt of equivalent risk is yielding 12% today. The company's common stock today is selling at $60 a share. Calculate the conversion value of the issue.

A) $1,000
B) $1,200
C) $ 800
D) $300

Question 56

PSW has warrants outstanding that have an exercise price of $10. Each warrant entitles the holder to purchase one share of PSW common stock. Last week PSW common stock was selling for $12 per share and, at the same time, the warrants traded at $5 each. Determine the warrant's premium over the formula value.

A) $0
B) $2
C) $3
D) $5

Question 57

Jackson Electronics (40% marginal tax rate) is considering issuing convertible debentures. Its investment banker tentatively has agreed to issue a 9.0 percent, 20-year convertible debenture ($1000 par value). The conversion price will be $50 a share. Jackson's financial managers only want to issue the convertible if its after-tax component cost of capital is less than or equal to 8.0 percent. Otherwise, they plan to issue non-convertible debt. Jackson's current common stock price is $43 a share. The company expects to call the convertible issue 5 years from now when the common stock price is expected to be $60 a share. Under the conditions given in this problem, what is the minimum price per debenture that Jackson can receive and keep the after-tax cost of capital for the debentures at 8.0%?

A) about $1,033
B) about $ 946
C) about $ 897
D) $1200

Question 58

What is the value of a CKS Food's option prior to expiration if the exercise price is $20 and the current stock price is $20?

A) greater than $0
B) $0
C) less than $0
D) can not be valued

Question 59

Lear Holdings plans to sell 60,000 units, each unit consisting of a $1,000 debenture and 15, 7-year warrants. Each warrant allows the holder to purchase one common-share at $30. If the stock price goes to $38 and all warrants were exercised, what is the total capital raised by Lear?

A) $94.2 million
B) $90.6 million
C) $87 million
D) $77 million

Question 60

The capital structure of Springmaid Company is as follows:
The company has decided to raise additional capital by selling $100 million of 8% debentures with warrants attached. Each $1000 debenture will have 40 warrants attached, and each warrant will entitle the holder to purchase one share of common stock at $20. Assume that no other changes in the capital structure occur between now and the time the warrants are exercised. Determine the contributed capital in excess of par account balance after exercise of the warrants.

A) $250 million
B) $330 million
C) $254 million
D) $326 million

Question 61

Conversion of a convertible security can occur in two ways. Which of the following is/are correct?
I) It can be a voluntary conversion at specific times prior to the expiration date.
II) It can be a forced conversion at any time prior to the expiration date.

A) I only
B) II only
C) Both I and II
D) Neither I nor II

Question 62

Which of the following is/are a feature of convertible securities?
I) Conversion price
II) Conversion stock

A) I only
B) II only
C) Both I and II
D) Neither I nor II

Question 63

Conversion price is:

A) the number of common stock shares owned after the conversion.
B) the effective price of the common stock per share obtained by converting.
C) the market price of the common stock per share.
D) the difference between the market price of the common stock and the exercise price of the stock.

Question 64

In calculating fully diluted earnings per share, earnings must be adjusted for:

A) interest saved.
B) the number of convertible securities in the marketplace.
C) the number of executive bonus packages that could impact the firm's earnings.
D) the company's credit rating.

Question 65

Why would a company issue convertible securities instead of straight bonds?

Question 66

The conversion ratio of a convertible security is:

A) the number of shares that can be obtained
B) the value of the shares obtained
C) the price at which the security is exchangeable
D) the loss in the security's value once it is exchanged.

Question 67

Firms issue warrants for which of the following reasons?
I) Allows the company to sell stock at a price above what other company stock is selling for.
II) Allows the company to choose which investors are allowed to buy the company's stock.

A) I only
B) II only
C) Both I and II
D) Neither I nor II

Question 68

Sam owns a $1000 par value, convertible bond which can be converted now. The conversion ratio is 20 and each share of stock is currently selling for $40 per share. What would be the conversion value of the bond, and should Sam convert the bond or hold it to maturity?

A) The conversion value is $2000 and Sam should convert.
B) The conversion value is $1200 and Sam should convert.
C) The conversion value is $975 and Sam should hold the bond to maturity.
D) The conversion value is $800 and Sam should hold the bond to maturity.

Question 69

What is an interest rate swap? Describe how they are used.

Question 70

An option has a ____ claim.

A) fixed
B) contingent
C) subordinated claim
D) superior claim

Question 71

What variables affect the call option valuation?

Question 72

Explain how conversion of a convertible security affects earnings and how does a firm handle this on its financial statements?

Question 73

Jana owns preferred stock from High Brow Cow Dairy Farms, makers of the finest dairy products. The stock has a par value of $1,250 and a conversion ratio of 25. The stock is currently convertible. The firm's common stock is selling for $57 per share. If Jana converts the preferred stock, what would be the conversion value?

A) $1,250
B) $31,250
C) $2,850
D) $1,425

Question 74

In comparing warrants and rights, they:

A) are similar in that the company can discriminate as to who buys new company stock.
B) are similar in that they allow the purchase of existing stock only
C) are different in that both allow the firm to receive additional funds at the time they are exercised.
D) are different in that rights allow the holder of the right to vote in corporate elections based on the number of shares the right can purchase.

Question 75

Which companies are the primary issuers of convertible securities and why do they do it?

Question 76

The value of the right can be calculated under one of the following circumstances.

A) using the Gordon model
B) trading ex-rights
C) market order
D) based on a margin account

Question 77

Conversion premium is the amount by which the market value of a convertible security is higher than:
I) the conversion value of the security
II) the combined interest or dividend payments of the security

A) I only
B) II only
C) Both I and II
D) Neither I nor II

Question 78

In general, when a convertible security is exchanged for common stock, the overall effect is which of the following?
I) stock shares will decrease
II) earnings per share will decrease.

A) I only
B) II only
C) Both I and II
D) Nether I nor II

Question 79

What is the difference between a conversion price and a conversion ratio?

Question 80

List some securities that have option features.