Preferred Stock Flashcards
Which statements are TRUE regarding the taxation of dividends received by investors?
I Individuals cannot exclude any dividends received from taxation
II Individuals can exclude 50% of dividends received from taxation
III Corporations cannot exclude any dividends received from taxation
IV Corporations can exclude 50% of dividends received from taxation
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
Corporations that receive dividends from investments held generally are allowed to exclude 50% of the dividends received from taxation. This exclusion does not apply to individual investors (however, individual investors get the benefit of taxation of cash dividends received at a substantially lower rate - 15% (or 20% for those in the highest tax bracket) - than do corporate investors). Thus, a corporation that receives dividends from common stock holdings, preferred stock holdings, or mutual fund holdings where the fund’s income is from common and/or preferred stock investments, is allowed to exclude 50% of that income from taxation.
A customer buys 100 shares preferred at $110 per share. The par value is $100. The dividend rate is 5%. Each dividend payment will be:
A. $250
B. $275
C. $500
D. $550
The best answer is A.
The annual rate is 5% X $100 par value = $5 per share X 100 shares = $500. Since preferred dividends are paid semi-annually, each payment is $250.
A customer buys 100 shares of preferred at $101 per share. The par value is $100. The dividend rate is 8%. Each dividend payment will be:
A. $80
B. $400
C. $800
D. $808
The best answer is B.
The annual rate is 8% X $100 par value = $8 per share X the number of shares = $800. Since preferred dividends are paid semi-annually, each payment would be $400.
Which statements are TRUE about preferred stock?
I When interest rates rise, preferred stock prices rise
II When interest rates rise, preferred stock prices fall
III When interest rates fall, preferred stock prices fall
IV When interest rates fall, preferred stock prices rise
A. I and II
B. I and III
C. II and III
D. II and IV
The best answer is D.
Preferred stock is a fixed income security, and hence, when market interest rates move, the only way for the yield on the security to adjust to the market is to have the price change. When interest rates rise, preferred stock prices fall, increasing the yield on the security; and when interest rates fall, preferred stock prices rise, decreasing the yield on the security.
ABC 8% $100 par preferred is trading at $105 in the market. The current yield is:
A. 6.6%
B. 7.6%
C. 8.6%
D. 10.6%
The best answer is B.
The formula for current yield is:
Annual Income
———————– = Current Yield
Market Price
$8
——– = 7.6 %
$105
ABC Company has issued 8%, $100 par, cumulative preferred stock. Two years ago, ABC paid a 4% preferred dividend. Last year, ABC paid a 5% preferred stock dividend. This year, ABC wishes to pay a common dividend. If the preferred stock is now trading at $94, a customer who owns 100 shares of the company’s preferred stock will receive:
A. $700
B. $800
C. $1,000
D. $1,500
The best answer is D.
Since this is cumulative preferred stock, all missed dividends must be paid before a common dividend can be paid. Two years ago, 4% was missed; last year 3% was missed; and this year’s preferred dividend of 8% must be paid before the common dividend is paid. The total preferred dividend to be paid is 15%.
A customer buys 1,000 shares of ABCD $25 par 8% cumulative preferred stock. This preferred issue pays quarterly dividends. This year, it missed the first 3 quarterly dividends. In the 4th quarter, it paid a common dividend of $.25 per share. In order to do this, it must have paid this preferred shareholder:
A. $400
B. $500
C. $1,600
D. $2,000
The best answer is D.
This customer owns 1,000 shares of $25 par cumulative preferred, for a face value of $25,000. In order to have paid the common dividend,the company must have paid the preferred shareholder the 3 missed quarterly dividends in addition to the current quarterly dividend. Therefore, it must pay the annual dividend amount of 8% of $25,000 = $2,000 to this preferred shareholder.
ABC Company has outstanding 6% cumulative preferred stock. Two years ago, ABC paid a 6% preferred dividend. Last year, ABC paid a 4% preferred stock dividend. This year, ABC wishes to pay a common dividend. The preferred shareholders must receive:
A. 0%
B. 2%
C. 6%
D. 8%
The best answer is D.
On cumulative preferred stock, all back unpaid dividends PLUS this year’s preferred dividend must be paid before a common dividend is paid. Thus, 2 years ago the full 6% preferred dividend was paid, so there is no arrearage; last year only 4% was paid, so 2% was missed. Before a common dividend can be paid this year, the missing 2% plus this year’s 6% preferred dividend, or a total of 8% must be paid.
Which security of the same issuer is likely to give the highest current yield?
A. warrant
B. common stock
C. convertible preferred stock
D. non-convertible preferred stock
The best answer is D.
Warrants give no yield. Common stocks give the lowest yields since there is direct growth potential in the price of the stock as reported earnings increase. Convertible preferred yields are higher than common yields but not as high as non-convertible yields. A non-convertible preferred stockholder gets a fixed rate of return without any growth potential. A convertible preferred stockholder can convert to common if the common’s price rises, so growth potential is included. Because of this, yields for convertible preferred are lower than for non-convertible preferred.
Which of the following statements are TRUE when comparing convertible preferred stock and non-convertible preferred stock?
I Convertible preferred issues will have a higher yield than similar non-convertible yields of the same issuer
II Non-convertible preferred issues will have a higher yield than similar convertible yields of the same issuer
III Convertible preferred stockholders can benefit as the common stock price rises
IV Non-convertible preferred stockholders can benefit as the common stock price rises
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
Non-convertible preferred yields are higher than convertible yields. A non-convertible preferred stockholder gets a fixed rate of return without any growth potential. A convertible preferred stockholder can convert to common if the common’s price rises, so growth potential is included. Because of this, yields for convertible preferred are lower than for non-convertible preferred.
A corporation issues $100 par convertible preferred stock, convertible at $20 per share, when the market price of the common is currently $10. Which statement is TRUE?
A. The conversion ratio is 10:1
B. The conversion ratio is 5:1
C. The conversion ratio is 2.5:1
D. The conversion ratio is 2:1
The best answer is B.
The conversion ratio is Par Value / Conversion Price.
$100 Par / $20 Conversion Price = 5:1 Conversion Ratio.
A corporation issues $50 par convertible preferred stock, convertible at $20 per share, when the market price of the common is currently $10. Which statement is TRUE?
A. The conversion ratio is 10:1
B. The conversion ratio is 5:1
C. The conversion ratio is 2.5:1
D. The conversion ratio is 2:1
The best answer is C.
The conversion ratio is Par Value / Conversion Price.
$50 Par / $20 Conversion Price = 2.5:1 Conversion Ratio.
If a corporation with outstanding callable convertible preferred stock, calls these shares in a “forced conversion” which of the following will happen?
I The number of common shares outstanding will increase
II The number of common shares outstanding will decrease
III Earnings per share will decrease
IV Earnings per share will increase
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
In a “forced conversion,” a corporation calls outstanding preferred stock or bonds that are trading at a price well above par, typically with no call premium (or a very small call premium). The better choice for the preferred shareholder is to convert into common, since the equivalent number of shares of common are worth more than the price at which the securities will be called. Thus, this forces the senior security holder to convert. When conversion occurs, the number of common shares increases, and hence, earnings per common share decreases.
A corporation has issued $100 par, 8% cumulative convertible preferred stock, callable at par. The preferred is convertible into 1.4 shares of common stock. Currently, the preferred stock is trading at $102 while the common stock is trading at $75.50. The corporation calls the preferred stock at par plus accrued dividends of $2 per share. The corporation is making a(n):
A. tender offer
B. forced conversion
C. advance refunding
D. simultaneous transaction
The best answer is B.
If a preferred stockholder converts and sells the stock in the market, he realizes the equivalent of 1.4 (conversion ratio) x $75.50 current market price = $105.70 per share. If he or she tenders the preferred on the call, he or she receives $100 per share. He or she will not continue to hold the preferred since dividend payments will cease. The best choice for the preferred shareholder is to convert. In effect, the corporation is forcing the shareholders to convert to common.
A corporation has issued $100 par, 4% cumulative convertible preferred stock, callable at par. The preferred is convertible into 4 shares of common stock. Currently, the preferred stock is trading at $103 while the common stock is trading at $26. If a customer buys 100 preferred shares, converts, and then sells the common stock in the market, the profit or loss is (ignoring commissions):
A. $100 gain
B. $100 loss
C. $7,400 gain
D. $7,400 loss
The best answer is A.
If the customer buys 100 shares of the preferred stock, he or she will pay 100 x $103 per share = $10,300. Since each share of preferred is convertible into 4 common shares, the 100 preferred shares will be converted into 4 x 100 = 400 common shares. The sale of 400 common shares at the current market price of $26 will yield $10,400. The net gain is: $10,400 - $10,300 = $100.
A corporation issues $100 par convertible preferred stock, convertible at $10 per share, when the market price of the common is currently $5. The preferred is issued under an “anti-dilutive covenant.” If the company declares a 25% stock dividend, which statements are TRUE?
I The conversion price remains at $10
II The conversion price is adjusted to $8
III The conversion ratio remains at 10:1
IV The conversion ratio is adjusted to 12.5:1
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is D.
Under an “anti-dilutive” covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $10 per share. If there is a 25% stock dividend, the new conversion price will be adjusted to $10/1.25 = $8 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/$8 = 12.5.
