Lesson 1.1: Equity Securities

Question 1

Three years ago, an investor purchased 1,000 shares of stock in the Equity Protective Life Insurance Company (EPLIC). The purchase price was $53 per share. The current market value of EPLIC stock is $79 per share. If the investor is in the 24% federal income tax bracket, it is correct to state that:

Answer 1

no tax is owed

Because the investor has not sold the EPLIC stock, the gain is unrealized. It is only when a gain (or loss) is realized that there are tax consequences. Had the stock been sold, it would have been a long-term capital gain, which is taxed at 15% rather than the investor’s marginal rate.

Question 2

Common stockholders & Preferred stockholders

Answer 2

Common and preferred stockholders have equity or ownership positions.

Question 3

Convertible bondholders & Mortgage bondholders

Answer 3

Bondholders (mortgage or otherwise) are creditors, not owners.

Question 4

Preferred stock

Answer 4

pays a fixed dividend & is usually nonvoting.

The dividend on preferred stock is fixed, and shares do not have voting rights.

Preferred stockholders do not have the right to subscribe to a rights offering.

Preferred stockholders have a preference as to liquidation and distribution of dividends, but the right to maintain a proportionate interest in the company only applies to common stock.

Question 5

Common stock

Answer 5

is less sensitive to interest rate risk than preferred stock.

The price of a common share generally doesn’t fluctuate with changes to interest rates in the same manner as that of preferred stock.

the right to maintain a proportionate interest in the company only applies to common stock.

Question 6

The board of directors of DDC omitted dividends in 2020 on their $100 par 6% noncumulative preferred stock. In 2021, a $2 preferred dividend was paid. For DDC, 2022 has been a good year, and the board wishes to pay a common dividend. How much must be paid per share on the preferred for 2022 in order to pay a common dividend?

Answer 6

$6

Because this preferred stock is noncumulative, any missed dividends need not be paid before common dividends can be declared. If this were a cumulative issue, any dividends not fully paid would go into arrears and accumulate until paid to the preferred cumulative stockholder. During this time, common dividends could not be declared or paid until the cumulative holders were paid in full. A 6% dividend on a $100 par means a $6 dividend each year per share.

Question 7

A company that has issued cumulative preferred stock:

Answer 7

pays past and current preferred dividends before paying dividends on common stock.

Question 8

Reasons why a corporation might issue a convertible preferred stock would include:

Answer 8

giving those shareholders an opportunity to participate in the future success of the company.

The benefit of any convertible security, debt security, or preferred stock is that the ability to convert into the issuer’s common stock allows those investors to participate in the potential future growth of the company. One does not convert into a bond, and because preferred dividends are an after-tax outlay, there are no tax savings, as there would be with bond interest. Because stock is lower in claim than bonds, the dividend rate would have to be higher than the interest rate on bonds.

Question 9

Julie owns 100 shares of CCC at $25. CCC declares a 25% stock dividend. After the ex-date, what will she own?

Answer 9

125 shares @ a Cost basis of $20

Remember that the ex-date is the first day on and after which a purchaser of a stock is not entitled to a previously declared dividend (cash or stock). That means the owner of the stock on and after the ex-date is the one who receives the cash or, in this case, the additional stock. The payment of a stock dividend causes the number of shares owned to increase while the cost per share decreases. The total value of the position will always remain unchanged. ** Julie had 100 shares at $25 per share, or $2,500, and now has 125 shares × $20 = $2,500.**

Question 10

The Record Date.

Answer 10

The record date is a date announced by the company as the official date you must be an owner on the company’s records in order to participate in the annual meeting and corporate election. A fact not tested is there is no standard regarding how far in advance of the voting date this should be other than it must be at least the normal settlement period, currently two business days.

Question 11

A client has 100 shares of GHI when the stock undergoes a split. After the split, the client has

Answer 11

no effective change in the value of the position.

When a stock splits, the number of shares each stockholder has either increases or decreases (in the case of a reverse split). The customer experiences no effective change in position because the proportionate interest in the company remains the same.

Question 12

Dividends on common stock:

Answer 12

Dividends represent a pro rata distribution of corporate profits to shareholders.

Only those who are owners of the stock on the record date will receive dividends.

Dividends may be paid in cash, property, or stock.

Dividends are the share of a corporation’s profits that the corporation pays to shareholders as owners of the corporation. Dividends are not paid to shareholders automatically, and shareholders have no contractual right to receive dividends. Instead, dividends must be declared by the corporation’s board of directors. The board of directors may elect to pay a dividend in cash, property, or stock.

Question 13

An investor in an equity security:

Answer 13

Equity means ownership, and this is a characteristic shared by both common and preferred stock. Holders of debt securities are creditors, and there are no guarantees when it comes to returns on equity securities. Only common stockholders have voting rights, but even then, those rights don’t deal with daily operations because the vote is generally used at the annual meeting to vote for members of the board of directors.

Question 14

An investor holding what equity securities would not expect to have preemptive rights?

Answer 14

Preferred stockholders do not have preemptive rights. Preemptive rights allow common stockholders to subscribe to additional issues of shares before they are offered to the public, to maintain their percentage ownership.

Question 15

Least exposure to inflation risk?

Answer 15

The returns on common stock have historically outperformed inflation, making them less vulnerable to loss of purchasing power. Cash is a store of present purchasing power that inflation will erode. Fixed annuities have more exposure to inflation than common stock because their payments are fixed in nominal dollars. Preferred stock has the same exposure to inflation risk as do all fixed-income instruments.

Question 16

A company’s dividend on its common stock is determined by ???

Answer 16

determined by its board of directors.

Question 17

An investor who chooses to use preferred stock as an income source instead of bonds would potentially incur which of the following risks? (Choose 3)

I. Loss of principal can occur.
II. Price volatility of preferred stock is closely related to interest rates.
III. Preferred stock cannot be traded as readily as bonds.
IV. If the stock is callable, the client’s income can be suddenly lowered.

Answer 17

I, II, IV
Because bonds have seniority over any equity security, there is a greater risk of loss of principal with preferred stock than with bonds. The price volatility of preferred stocks, like bonds, is impacted by interest rate changes. Unlike bonds, however, preferred stock does not have a maturity date. This means that preferred shares may never return to their par value, as bonds do at maturity date. Because the preferred stock may have a callable feature, the company can redeem its shares anytime after the call protection period (if any) is over. This usually happens when interest rates have declined, so the client whose stock was called will not be able to reinvest the proceeds at the same rate and could, therefore, suffer an unexpected drop in income. Preferred shares, particularly those listed on the exchanges, are generally easier to trade than corporate bonds (and certainly no worse).

Question 18

Which of the following statements regarding a 100% stock dividend are true?

I. The share price is reduced by half.
II. The total market value of the outstanding stock decreases.
III. The total market value of the outstanding stock may increase or decrease as a result of the split.
IV. The number of shares doubles.

Answer 18

I & IV
In a 100% stock dividend, the number of outstanding shares is doubled and the price is reduced by half. The total market value (market cap) of the issuer’s stock remains the same.

Question 19

One of the features of convertible preferred stock is that owner:

Answer 19

has the opportunity to participate in the growth of the company.

Any convertible security, preferred stock, or debenture is convertible into the issuer’s common stock. As a result, if the business is successful, the common stock’s price will rise to the point where conversion is a wise idea. Although the investor can generally select when to convert, the conversion price or ratio is set at the time of issuance. Interest on debt securities is paid before the dividends on any stock. When it comes to preferred stock, there is frequently a pecking order, such as a prior lien preferred or first preference preferred that would come ahead of the other preferred shares.