Chapter 3

Question 1

capital loss

Answer 1

• capital losses can be used to offset capital gains only
• Capital losses are deducted from ordinary income, and therefore, reduce tax liability. The maximum that individuals or married couples can deduct is $3,000 annually. If the long-term capital loss exceeds the maximum, the excess is carried forward to future years until the loss is exhausted. Under current IRS regulations, $1 in losses results in $1 in deductions.

Question 2

Stock prices in the over-the-counter (OTC) market are determined by

Answer 2

• negotiation between buyers and sellers
• The OTC market is a negotiated market (not an auction market as is the case with an exchange) in which dealers negotiate stock trades with each other

Question 3

All of the following securities trade in the over-the-counter (OTC) market except

Answer 3

• open-end investment companies
• Municipal bonds, government and agency securities, and corporate securities (listed and unlisted) all trade in the OTC market. Foreign securities trade in the United States if the companies comply with SEC registration and disclosure requirements. Mutual fund shares (open-end companies) do not trade

Question 4

A sophisticated investor wants to purchase stock of a foreign company or an American depositary receipt (ADR) representing the shares of that company. The purchase would align with the investor’s goal of growth and income, but he makes several statements about the potential purchase, and only one of them is accurate. You feel it is important to point out and discuss from a suitability perspective which statements were and were not accurate. Which of the following is the accurate statement

Answer 4

• The purchase of ADRs representing the shares exposes me to currency risk
• From a suitability perspective, correcting any inaccuracies about an investment that an investor might have is important. Currency risk cannot be avoided when investing in foreign companies, either directly or using ADRs. While ADRs trade on U.S. exchanges, foreign shares do not, and ADR issuers generally do not pass on voting rights to the ADR holders

Question 5

The rate on an adjustable preferred stock may be indexed to

Answer 5

• the Treasury bill rate
• The dividend on an adjustable rate preferred stock is tied to a particular interest rate, and the Treasury bill rate is a common benchmark

Question 6

Holders of common shares may generally vote on

Answer 6

• whether the company should issue additional preferred stock
• Common shareholders must vote to approve the issuance of additional preferred stock because additional preferred shares dilute the common shares’ residual assets under a liquidation. Common shareholders do not vote to declare dividends. Board members select the chairman of the board. Shareholders do not get involved in the daily operational activity of the corporation

Question 7

Your customer wishes to invest in a security that will pay a specific level of dividends, but may also receive additional dividend amounts, should the underlying company have outstanding performance. Which of the following securities would best match this customer’s objectives?

Answer 7

• Participating preferred stock
• Participating preferred stock provides a stated dividend amount (as a percentage of par value) plus the opportunity to receive additional dividends, based on predetermined conditions, such as the profitability level of the underlying company. Although the convertible stock offers the possibility of capital appreciation due to its linkage to the common stock, that has no effect on the dividend.

Question 8

An investor purchased 200 shares of DCAST common stock at $200 per share. What is the adjusted cost basis per share of this position after the company pays a 100% stock dividend?

Answer 8

• $100
• The total value of the initial position is unchanged, remaining at $40,000 (200 times $200). After the stock dividend, the investor owns 400 shares (200 times 100% = 200 + 200 = 400). Therefore, the adjusted cost basis is $100.00 per share ($40,000 divided by 400 = $100). Perhaps you recognized that a 100% stock dividend has the same effect as a 2:1 split. That is, the stock’s cost basis is cut in half. It is important to remember that anytime there is a distribution resulting in additional shares (stock split, stock dividend), the cost basis per share is reduced while the total account value remains the same.

Question 9

The Securities Exchange Act of 1934 regulates or mandates all of the following except

Answer 9

• full and fair disclosure on new offerings.
• The Securities Exchange Act of 1934 created the SEC and regulates the secondary market. The Securities Exchange Act of 1934 does not address full and fair disclosure issues; the Securities Act of 1933 addresses these issues.

Question 10

One of your clients owns 300 shares of common stock in a publicly traded corporation. The acquisition cost of those shares was $60,000 and the last trade of the stock was $220 per share. There was a news report that the company was going to pay shareholders a 100% stock dividend. The client wants to know how this dividend will affect the holding. You would respond that the customer will

Answer 10

• now own 600 shares and the market price will be approximately $110 per share
• The effect of a 100% stock dividend is the same as a 2:1 stock split. The customer will have twice as many shares worth half as much each. That would be 600 shares worth $110 per share for a total value of $66,000. Note that the total value is unchanged from the pre-split value of 300 shares at $220 per share.

Question 11

When comparing preemptive rights and warrants, one similarity is

Answer 11

• their voting privilege
• In an odd play on words, the only similarity here is that neither of them have voting rights. Warrants are long-term while rights are short-term. The exercise price of a right is below the current market while that of a warrant is above. Only rights are distributed to existing shareholders in proportion to the investor’s current stock ownership. Warrants are not sent to shareholders; they are most often part of another issue

Question 12

outstanding stock

Answer 12

issued stock - treasury stock = outstanding stock

authorized stock and issued stock are two different things

Question 13

residual right to claim

Answer 13

• common stockholder right after all debts and security holders have been satisfied
• common stockholder has the last claim (junior security)

Question 14

forward stock split

Answer 14

• increases the number of shares, reduces the price without affecting the total market value of shares outstanding
• investors receive more shares but the value of those shares is reduced

Question 15

reverse split

Answer 15

-investors own fewer shares that are worth more per share

Question 16

stock dividend

Answer 16

-if an investor owned 100 shares of the stock and and the company declared a 20% stock dividend the investor would receive 20 additional shares bringing the total value up to 120 shares

Question 17

voting rights

Answer 17

• vote for BOD
• issuance of convertible securities or additional common stock
• declarations of stock splits (forward and reverse)

Question 18

statutory & cumulative voting

Answer 18

• cumulative voting benefits the smaller investor, whereas statutory voting benefits larger shareholders
• shareholders don’t vote on dividend related matters
• they vote on stock splits, board members, and issuance of additional equity-related securities such as common stock, preferred stock and convertible securities

Question 19

preemptive rights

Answer 19

• gives investors the right to maintain a proportionate interest in a company’s stock
• if a customer owns 100,000 shares or 10% and a company issues an additional 500,000 shares, the customer willhave the opportunity to purchase 50,000 of those shares

Question 20

ABC, Inc., has 1 million shares of common stock outstanding ($10 par value), paid-in surplus of $10 million, and retained earnings of $20 million. If ABC stock is trading at $20 per share, what would be the effect of a 2-for-1 stock split?

Answer 20

• The par value would decrease to $5 per share.
• A stock split results in more outstanding shares at a lower par value per share. In the case of a 2-for-1 split, there are twice as many shares (2 million) and the par value is cut in half ($10 ÷ 2 = $5) The total par value of stock outstanding is unchanged ($2 million times $5 = the same $10 million in total par value). Remember, a 2:1 split is the same as changing a $10 bill for two $5 bills. Retained earnings are not affected by a stock split. Although not part of this question, the market value of the stock would be approximately $10 per share (half of the $20 per share before the split).

Question 21

Synapse Communication Corporation (SCC) is growing. To finance the expansion, the company has a $100 million debenture offering. Attached to the offering are five-year warrants to purchase SCC common shares. Each warrant allows for the purchase of two SCC shares at a price of $53 per share. Three years after the issue date, SCC stock is trading at $63 per share. Each warrant has

Answer 21

• an intrinsic value of $20
• A warrant has intrinsic value when the exercise price is lower than the stock’s current market price. In this question, each warrant allows the holder to purchase two shares of a $63 stock for $53 per share. That is a $10 per share value times two. Therefore, intrinsically, the warrant is worth $20. With two years to go, it also has time value, but the question is not dealing with that. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.

Question 22

One of the primary differences between rights and warrants is

Answer 22

• warrants have a life before expiration that is much longer than rights.
• Warrants have an expiration date that often runs as long as 5 years. In fact, there is no legal maximum, but it is rare to see one with an expiration date longer than 10 years from issuance. On the other hand, most rights expire within 30-45 days and it is rare to see one with a life exceeding 60 days. Both rights and warrants provide the holder with the ability to acquire shares of common stock at a specified price. The exercise of each will result in additional shares outstanding and will cause earnings per share to decline. Both instruments are marketable and may trade in the secondary market.

Question 23

One of your clients asks about a recent purchase of a preferred stock. When looking at online information about the stock, the client notices that no par value is assigned. How does the company determine the amount of dividend to be paid?

Answer 23

• On a no-par preferred stock, the dividend is a stated rate.
• When a preferred stock is issued without a stated or par value, the dividend rate is stated in dollars. For example, it could be a $2 preferred. That would mean quarterly dividends of $0.50; $2 per year. Although the company is under no obligation to pay a preferred dividend (unless it plans to pay a dividend on its common stock), and the board of directors can pay a partial dividend, that does not mean the dividend can be increased over the stated rate.

Question 24

Which of the following statements is true regarding dividend payments on common stock?

Answer 24

• Dividends on common stock are paid at the discretion of the board of directors and may be paid even where there are no earnings.
• Dividends on common stock are paid at the discretion of the corporation’s board of directors. Although each stockholder receives an amount proportionate to their holdings, the dividend can be any proportion of the company’s earnings. In fact, a corporation can pay a dividend even when there are no earnings. However, no dividend on common stock can ever be paid before payment of the dividends due on preferred stock.

Question 25

Your customer wishes to invest in a security that will pay a specific level of dividends, but may also receive additional dividend amounts, should the underlying company have outstanding performance. Which of the following securities would best match this customer’s objectives?

Answer 25

• Participating preferred stock
• Participating preferred stock provides a stated dividend amount (as a percentage of par value) plus the opportunity to receive additional dividends, based on predetermined conditions, such as the profitability level of the underlying company. Although the convertible stock offers the possibility of capital appreciation due to its linkage to the common stock, that has no effect on the dividend.

Question 26

It would be correct to describe a warrant in all of the following ways except

Answer 26

• the exercise price is generally slightly below the current market price.
• Warrants always carry an exercise price that is above the current market price of the underlying security. The upside potential is viewed as a sweetener for other issues, particularly bonds. This results in the issuer borrowing at a lower interest cost. Unlike preemptive (stock) rights that have a short life, warrants do not expire for a long time, sometimes five years or longer.

Question 27

One of your customers has asked you about trading penny stocks. After discussing the risks, the customer decides to go ahead. The firm sends the individual a copy of the special penny stock risk disclosure document. The firm needs the customer’s signed and dated acknowledgment of receipt of the document. Trading in penny stocks may not begin in that account until

Answer 27

• at least two business days after sending the statement
• It is SEC Rule 15g-2 that requires the firm to wait at least two business days after sending the risk disclosure document before executing the first penny stock trade for a new customer. The $25,000 is the minimum equity in a pattern day trading account.

Question 28

A convertible preferred stock issue (par value $100) is selling at $125 and is convertible into five shares of common stock. The conversion price of the common stock is

Answer 28

• $20
• Par value divided by conversion price equals the number of shares into which the security is convertible. If this security is convertible into five shares, we need to know what number goes into $100 five times. That number is $20. The current market value of the preferred stock is unnecessary information.

Question 29

Which of the following transactions would not be subject to the 5% markup policy?

Answer 29

• Your client enters trades to purchase two different mutual funds in the same fund family. The combined purchases do not qualify for any breakpoints. The client is charged a sales charge of 6.5%.
• It is important to understand that the FINRA Markup Policy is a guide, not a rule. The policy describes the various factors that a member firm should consider when determining the markup, markdown, or commission to charge in any given transaction. Because securities sold by prospectus have a stated offering price per share, a guide is unnecessary; the price is the price. In the case of mutual funds, which are always sold by prospectus, the formula for computing the price (NAV plus the sales charge, if any) is clearly listed in that prospectus. Once again, member firms do not need a guide; the price is the price. The policy is frequently referred to as the five percent policy, but that number is simply a guideline, and the broker-dealer’s charge can exceed that percentage, especially in the case of a small transaction, such as one share at $26.

Question 30

A customer sells securities and uses the proceeds to buy more securities at the same cost. Under the 5% markup policy, the markup is calculated on

Answer 30

• the total of both sides

- The firm must consider the entire transaction (a proceeds transaction) when calculating the markup.

Question 31

Before effecting a penny stock transaction with a customer, the member firm must

Answer 31

• provide the customer with a current bid and asked quote on the stock.
• To avoid price gouging, SEC Rule 15g-3 requires that no penny stock transaction may take place without the member firm providing the customer with the current inside market quotes. Those are the highest bid and the lowest ask price currently quoted. The current quotes are more important to the customer than the most recent trade because that trade may have been hours or even days ago. Trading may commence two business days after sending the risk disclosure document.

Question 32

An investor owns 300 shares of XYZ common stock, currently selling for $50 per share. The investor also owns 100 shares of XYZ’s 5% $100 par preferred stock currently trading at $90 per share. A 2:1 stock split is declared. After the payment date, the investor will own

Answer 32

• 600 shares of common at $25 per share and 100 shares of the preferred at $90 per share.
• A stock split is always of common stock. In a 2:1 split, the number of shares doubles, and the price is 50% of the presplit price, which means 600 shares at $25 per share. The stock split has no effect on the preferred stock.

Question 33

GIN Corporation is offering shareholders the right to subscribe to a new issue of stock at $30 per share. The current market price of the GIN stock is $44 per share, and it takes 20 rights plus the subscription price to purchase one share. The theoretical value of a single right, prior to the ex-rights date, is approximately

Answer 33

• $0.67.
• Because this is cum rights (before the ex-rights date), the formula is M ‒ S

N + 1

Thus, $44 ‒ $30 = 14 ÷ 21 = $0.67

20 + 1

Question 34

The KPL Corporation is considering having its stock listed on the New York Stock Exchange (NYSE). Who will make the final decision as to whether it will be listed?

Answer 34

• The NYSE
• The NYSE has certain requirements that a company must meet before its stock can be considered for listing. Because the NYSE sets the requirements, it must make the final decision.

Question 35

The rate on an adjustable preferred stock may be indexed to

Answer 35

• the Treasury bill rate.
• The dividend on an adjustable rate preferred stock is tied to a particular interest rate, and the Treasury bill rate is a common benchmark.

Question 36

If a corporation attaches warrants to a new issue of debt securities, which of the following would be a resulting benefit to the corporation?

Answer 36

• Reduction of the debt securities’ interest rate
• Usually, a warrant is issued along with a debt instrument, which is an enhancement that allows the issuer to offer a slightly lower interest rate.

Question 37

Holders of common shares may generally vote on

Answer 37

• whether the company should issue additional preferred stock.
• Common shareholders must vote to approve the issuance of additional preferred stock because additional preferred shares dilute the common shares’ residual assets under a liquidation. Common shareholders do not vote to declare dividends. Board members select the chairman of the board. Shareholders do not get involved in the daily operational activity of the corporation.

Question 38

If all other factors are equal, an investor would expect which type of preferred stock to pay the highest stated dividend rate?

Answer 38

• Callable
• When the stock is called, dividend payments are no longer made. With callable preferred stock, to compensate for that possibility, the issuer pays a higher dividend than with straight preferred. Cumulative and convertible preferred have positive characteristics that would justify a lower fixed dividend than straight.

Question 39

One of the primary differences between rights and warrants is

Answer 39

• warrants have a life before expiration that is much longer than rights.
• Warrants have an expiration date that often runs as long as 5 years. In fact, there is no legal maximum, but it is rare to see one with an expiration date longer than 10 years from issuance. On the other hand, most rights expire within 30-45 days and it is rare to see one with a life exceeding 60 days. Both rights and warrants provide the holder with the ability to acquire shares of common stock at a specified price. The exercise of each will result in additional shares outstanding and will cause earnings per share to decline. Both instruments are marketable and may trade in the secondary market.

Question 40

A customer has $12,000 of capital gains, $15,000 of capital losses, and $50,000 adjusted gross income. How much unused loss is carried forward to the following tax year?

Answer 40

• $0
• After netting capital gain and losses, the customer has a net capital loss of $3,000. Because $3,000 of net losses can be deducted from income in any single tax year, there is no carryforward.

Question 41

Before effecting a penny stock transaction with a customer, the member firm must

Answer 41

• provide the customer with a current bid and asked quote on the stock.
• To avoid price gouging, SEC Rule 15g-3 requires that no penny stock transaction may take place without the member firm providing the customer with the current inside market quotes. Those are the highest bid and the lowest ask price currently quoted. The current quotes are more important to the customer than the most recent trade because that trade may have been hours or even days ago. Trading may commence two business days after sending the risk disclosure document.

Question 42

A registered representative has a customer looking to invest in stock for income. The customer is looking for the highest fixed rate of return available based on her risk profile. Which of the following would be least suitable?

Answer 42

• Convertible preferred
• Convertible preferred stock is convertible into the issuer’s common stock. This conversion feature has value if the market price of the underlying stock should increase. Because of that feature, issuers are able to attract investor interest with a lower dividend on this preferred stock compared with preferred stock that has no conversion feature. Therefore, it would be the least suitable investment for this client.

Question 43

An investor who purchased 100 shares of PERD common stock on June 30, 2020, would receive long-term capital gain treatment if the stock is sold at a profit starting

Answer 43

• July 1, 2021
• Investors must own a security for more than 12 months before it becomes long term for tax purposes. The first day after June 30, 2020, is July 1, 2020. Twelve months later is July 1, 2021. Remember, there is no June 31.

Question 44

If a company splits its stock 3 for 2, how many additional shares will be issued to an investor who owns 200 shares?

Answer 44

• 100
• The investor will receive an additional 100 shares from a 3-for-2 stock split. To calculate the additional shares as a result of a split, multiply the existing number of shares by the split rates (200 shares × 3/2 = 300 shares). Because the investor owned 200 shares, she will be issued 100 additional shares, bringing ownership to 300 shares.