Equity & Debt Securities

Question 1

XYZ Corporation has a large amount of equity securities outstanding. These securities could include:

I. XYZ common stock
II. XYZ 6% cumulative preferred stock
III. XYZ 4% convertible debentures
IV. XYZ 5% collateral trust certificates

a. I only
b. I and II only
c. II and III only
d. III and IV only

Answer 1

b. I and II only

Equity represents ownership in a corporation. The two kinds of equity stock a corporation issues to raise money are common stock (I) and preferred stock (II). Bonds (III and IV) represent debt owed by the corporation.

Question 2

Which of the following would be considered a defensive stock?

a. An aerospace stock
b. A utility stock
c. An airline stock
d. An automobile stock

Answer 2

b. A utility stock

Utility, food, beer, candy, tobacco, and soft drink stocks would be considered defensive stocks. They would offer the investor a greater amount of safety because in periods of recession and adverse economic conditions these companies would be the last to be affected. However, in an economic expansion, they would not appreciate as much as cyclical stocks.

Question 3

An investor would have the right to buy the stock of a corporation for the longest period of time by purchasing a:

a. Right
b. Call option
c. Put option
d. Warrant

Answer 3

d. Warrant

A warrant is the right to purchase a fixed number of shares, at some future time, at a fixed price. This is also true of rights and call options but warrants may be exercised over a longer period of time. A put option is the right to sell securities at a fixed price within a fixed period of time.

Question 4

A municipal bond backed by the full faith and credit of a state or city is called a(n):

a. Debenture bond
b. Revenue bond
c. General obligation bond
d. Income bond

Answer 4

c. General obligation bond

A general obligation bond is a municipal bond backed by the “full faith and credit” of a state or city. This means the municipality has promised to use its taxing power to raise revenue to pay principal and interest on the bonds.

Question 5

Which of the following would have the LEAST amount of interest-rate risk?

a. A Treasury bond maturing in 30 years
b. A newly-issued GNMA backed by 15-year mortgages
c. A Treasury STRIP maturing in 8 years
d. A BB-rated corporate debenture that matures in 2 years

Answer 5

d. A BB-rated corporate debenture that matures in 2 years

Interest-rate risk is primarily related to the maturity of a bond. The longer the bond’s maturity, the more interest-rate risk it has. In this case, the 2-year debenture has the least interest-rate risk because it has the shortest maturity. Note, however, that its below investment-grade rating translates into the greatest amount of credit risk of the securities listed.

Question 6

Corporations with highly leveraged capitalizations have raised most of their money by:

a. Incurring debt in the form of long-term bank loans and long-term bonds
b. Issuing equity securities in the form of common stock
c. Issuing convertible preferred stock
d. Doing any or all of the above

Answer 6

a. Incurring debt in the form of long-term bank loans and long-term bonds

Corporations with highly leveraged capitalizations have raised most of their money by incurring debt in the form of long-term bank loans and long-term bonds.

Question 7

Common and preferred stock are similar in that:

a. Both have a fixed dividend
b. The dividends for both must be declared by the board of directors
c. Both are guaranteed to receive an annual dividend
d. Both have an equal vote on corporate issues

Answer 7

b. The dividends for both must be declared by the board of directors

Dividends for both common and preferred stock must be declared by the board of directors. While preferred stock normally has a fixed dividend, neither common nor preferred stock are guaranteed a dividend.

Question 8

A U.S. government bond is selling in the market at 95.28. The dollar value of this bond is:

a. $950.87
b. $952.80
c. $958.75
d. $9,587.50

Answer 8

c. $958.75

U.S. government bonds are quoted in full points and 32nds of a point. A price of 95.28 would be 95 28/32, which is 95.875 percent of the par value of $1,000, or $958.75.

Question 9

ABC Corporation’s charter authorized the issuance of up to 1,000,000 shares of stock. The company has issued 100,000 shares, but has 5,000 shares of treasury stock. How many shares of ABC’s stock are outstanding?

a. 95,000
b. 100,000
c. 105,000
d. 900,000

Answer 9

a. 95,000

The number of shares outstanding is equal to the number of shares issued, minus any treasury stock (stock the company has bought back in the open market). 100,000 shares issued minus 5,000 shares of treasury stock = 95,000 shares outstanding.

Question 10

An individual who owns preferred stock receives a larger dividend than stated on its face. The preferred stock could be:

I. Cumulative preferred
II. Participating preferred
III. Preemptive preferred
IV. Collateralized preferred

a. III only 
b. I and II only 
c. I, II, and III only 
d. I, II, III, and IV

Answer 10

b. I and II only

An owner of cumulative preferred stock must receive all omitted past dividends before common stockholders can receive any dividends. A participating preferred stockholder has the right to participate in any extra dividends paid to the common stockholders. Therefore, owners of either of these types of preferred stock might receive more money on a given dividend payment than the amount stated on its face.

Question 11

Preemptive rights give a stockholder the right to:

a. Maintain his or her proportionate interest in the corporation
b. Purchase warrants
c. Serve as a director
d. All of the above

Answer 11

a. Maintain his or her proportionate interest in the corporation

A stockholder’s preemptive rights gives the stockholder the right to maintain his or her proportionate interest in the corporation. For example, if a shareholder owns 1% of the corporation’s common stock, and the corporation intends to issue additional shares, preemptive rights would give that shareholder the option of purchasing 1% of the new shares.

Question 12

Bond issues with staggered maturity dates are known as:

a. Adjustment bonds
b. Sinking fund bonds
c. Serial bonds
d. Purchase money bonds

Answer 12

c. Serial bonds

Bonds with staggered maturity dates are known as serial bonds. The principal amount outstanding is reduced over time. Term bonds mature on one single maturity date.

Question 13

An investor has a need for high liquidity with low principal risk. Which of the following would you recommend as a suitable investment based on this investment criteria?

a. Treasury bonds
b. Municipal bonds
c. Treasury bills
d. Corporate bonds

Answer 13

a. Treasury bonds

Based upon the investor’s investment criteria, Treasury bills would be most suitable. Since a Treasury bill is a short-term instrument (maturing in one year or less), it has a low principal risk. There is also a considerable secondary market for Treasury bills, making them highly liquid.

Question 14

An investor owns 3,000 shares of Regressive Inc. The company is splitting its stock 3 for 1. Immediately before the split, an investor’s stock is worth approximately $33,000. Immediately after the split, the investor would own?

a. 1,000 shares worth approximately $99,000
b. 3,000 shares worth approximately $11,000
c. 9,000 shares worth approximately $33,000
d. 9,000 shares worth approximately $11,000

Answer 14

c. 9,000 shares worth approximately $33,000

If a stock splits 3-for-1, the investor will own three times the number of shares after the split (3,000 x 3 = 9,000 shares). However, the market will adjust the per share value of the stock downward by the inverse of the split ratio. The result is that the total value of the investor’s holding will remain unchanged.

Question 15

Which of the following risks affects bonds primarily when interest rates decline?

a. Call risk
b. Credit risk
c. Political risk
d. Currency risk

Answer 15

a. Call risk

When interest rates decline, bond issuers are more likely to call in existing, higher interest rate bonds and replace them by issuing bonds paying lower rates. Investors whose bonds are called are then faced with reinvesting their principal at lower rates.

Question 16

A corporate bond that has no specific collateral backing it and is guaranteed by the full faith and credit of the issuing corporation is called a(n):

a. Debenture
b. Guaranteed bond
c. Income bond
d. Equipment trust certificate

Answer 16

a. Debenture

A corporate bond that has no specific collateral backing it and is guaranteed by the full faith and credit of the issuing corporation is called a debenture. A strong, financially sound, well regarded company is able to borrow money backed by its full faith and credit and its reputation and does not have to provide collateral as a guarantee.

Question 17

Interest on U.S. government bonds is:

a. Subject to federal and state income tax
b. Exempt from federal and state income tax
c. Subject to state income tax but exempt from federal income tax
d. Subject to federal income tax but exempt from state income tax

Answer 17

d. Subject to federal income tax but exempt from state income tax

Interest on U.S. government bonds is subject to federal income tax but exempt from state income tax. This is just the opposite of the tax treatment on municipal (state) bonds, where the interest is exempt from federal tax but subject to state tax. This is due to the doctrine of the separation of powers between the federal government and state governments. Each government can tax the interest on its own obligations, but cannot tax the other’s. In addition, states usually do not tax the interest received from their obligations owned by residents of that particular state and, in effect, interest is completely tax-free.

Question 18

A customer buys a 6% bond at 102 7/8. The buyer will have to pay the seller of the bond:

a. $1,000.00
b. $1,027.80
c. $1,027.80 + accrued interest
d. $1,028.75 + accrued interest

Answer 18

d. $1,028.75 + accrued interest

The buyer will have to pay 102 7/8 (102.875%) of the par value of $1,000, which is $1,028.75 plus accrued interest. All interest-bearing bonds (those that make regular coupon payments) trade with accrued interest (which the buyer must pay to the seller) unless the bonds are selling “flat”, which means without accrued interest.

Question 19

When comparing high quality bonds to lower quality bonds, the higher quality bonds will have which two of the following?

I. Lower market prices
II. Higher market prices
III. Lower yields
IV. Higher yields

a. I and III 
b. I and IV 
c. II and III 
d. II and IV

Answer 19

c. II and III

High quality bonds have a low level of risk and provide investors with a lower rate of return (yield). Since high quality bonds are considered safe investments, they generally have a high market price. As a rule of thumb: the greater the risk, the greater the return; the lower the risk, the lower the return.

Question 20

Which of the following shares would be paid a dividend if the common stock were paid a dividend?

I. Cumulative preferred
II. Convertible preferred
III. Participating preferred

a. I only
b. I and II only
c. II and III only
d. I, II, and III

Answer 20

d. I, II, and III

Dividends on preferred stocks must be paid prior to any common stock dividends. In this question, you are told that dividends were already paid to common stockholders. Therefore, all preferred stockholders must have been paid a dividend. Convertible preferred stock is convertible into common stock at a specified price; participating preferred stock gives the holder the right to participate in any extra dividends that are paid to common stockholders; and the holder of cumulative preferred stock will be entitled to any dividends that have been omitted prior to a current dividend payment.

Question 21

The call premium of a bond refers to the amount:

a. An investor must pay above par to buy a callable bond
b. Over par value that the issuer must pay to exercise the call privilege
c. The issuer must add to the semiannual interest payments to offset the call feature
d. Added to the price at issuance to compensate for the call privilege

Answer 21

b. Over par value that the issuer must pay to exercise the call privilege

The call premium of a bond refers to the amount the issuer must pay in excess of par value to exercise the call privilege. For example, if a bond is callable at 102, it has a 2 point ($20) call premium. The issuer must pay $1,020 ($20 more than par) if it wishes to call in the bond.

Question 22

Which of the following is true regarding a call option?

a. The owner has the right to buy stock
b. The owner has the right to sell stock
c. The owner has an obligation to buy stock
d. The owner has an obligation to sell stock

Answer 22

a. The owner has the right to buy stock

The owner of a call option has the right to buy stock (call stock) at the exercise price until the option expires. The owner pays a premium to the writer to obtain this option and has limited risk with the potential for unlimited profit. The risk is the possibility of losing the entire premium (cost of the option). Furthermore, the owner of the call option is not an equity owner of the stock unless the option is exercised.

Question 23

Which of the following statements is TRUE about a bond selling above par?

I. The current yield is lower than the nominal yield.
II. The nominal yield is lower than the current yield.
III. The yield-to-maturity is lower than the nominal yield.
IV. The nominal yield always remains fixed.

a. I and III only
b. I and IV only
c. I, III, and IV only
d. II, III, and IV only

Answer 23

c. I, III, and IV only

Bond prices and yields have an inverse relationship; as a bond’s price increases, its yield decreases. Conversely, as prices decrease, yields increase. When a bond is selling above its par value, both the current yield and yield to maturity are below the nominal yield. The nominal yield is printed on the face of the bond and remains fixed for the life of the bond.

Question 24

A method of voting which gives stockholders with substantial holdings a greater degree of voting power over those stockholders who own fewer shares would be

a. Statutory voting
b. Cumulative voting
c. Voting by proxy
d. Special majority voting

Answer 24

a. Statutory voting

A method of voting which gives larger, more substantial stockholders a greater degree of voting power over smaller, less substantial stockholders is called statutory voting. Under statutory voting, each stockholder has one vote per share owned for each separate election. Cumulative voting allows stockholders to concentrate all of their votes on one director’s position, increasing the power of smaller shareholders.

Question 25

Which of the following bonds would be considered the safest investment if credit risk is the primary concern?

a. Income bonds
b. Subordinated debenture bonds
c. Junk bonds
d. Closed-end mortgage bonds

Answer 25

d. Closed-end mortgage bonds

The safest bond would be the closed-end mortgage bond. Not only is it secured by a mortgage on real property, “closed-end” means that no further debts can be incurred on that same property.