Unit 1 Types & Characteristics of Equity Securities (Study Guide)

Question 1

What is a Security?

Answer 1

An investment that represents either an ownership stake or a debt stake.

Question 2

What is Common Stock?

Answer 2

Equity (ownership) in a corporation.

Question 3

Does Preferred Stock have voting rights? Y/N

Answer 3

Yes

Question 4

Preffered Stock, like Common Stock, represents ownership in a company. Is the price of Preferred Stock more like a bond?

Answer 4

Yes, with its fixed dividend payment, it is price sensitive to interest rate changes.

Question 5

What is Capital Appreciation?

Answer 5

An increase in the market price of securities.

Question 6

An increase in he market price of securities is?

Answer 6

Capital Appreciation

Question 7

What are Stock Dividens?

Answer 7

Dividend paid out in additional shares of common stock.

Question 8

What type of dividend is paid out in additional shares of common stock?

Answer 8

Stock Dividends

Question 9

What is a Stock Split?

Answer 9

An accounting process whereby the corporation exchanges new shares for old ones while changing the number of shares outstanding in the marketplace.

Question 10

What is important about limited liability?

Answer 10

In the event of bankruptcy of a corporation, the stockholder’s personal assets are not at risk.

Question 11

What is the liquidity of stock?

Answer 11

In almost all cases, common and preferred stock are freely transferable. No permission is required in order to sell their stock in the open market.

Question 12

What is the protection for a stockholder in the event of bankruptcy of a corporation, where the stockholder’s personal assets are not at risk.

Answer 12

Limited Liability

Question 13

Why include common stock in a client’s portfolio?

Answer 13

• Potential capital appreciation
• Income from dividends
• Hedge against inflation

Question 14

By including common stock in a client’s portfolio, the client would be incurring the following risks:

Answer 14

Market Risk
Business Risk
Low Priority at Dissolution

Question 15

What is Market Risk?

Answer 15

The chance that a stock will decline in price is one risk of owning common stock (known as market risk).

Question 16

What type of risk of common stock ownership is the possibility of a decline in the company’s earnings. This could lead to a reduction or even elimination of the dividend.

Answer 16

Business Risk

Question 17

What is a business risk of common stock?

Answer 17

A risk of common stock ownership is the possibility of a decline in the company’s earnings. This could lead to a reduction or even elimination of the dividend.

Question 18

What does common stock risk, Low Priority at Dissolution, mean?

Answer 18

If a company enters bankruptcy, the holders of its bonds and preferred stock have priority over common stockholders. A company’s debt and preferred shares are considered senior securities.

Question 19

What types of preferred stock are there?

Answer 19

Straight (Noncumulative); Cumulative Preferred; Callable Preferred; Convertible Preferred; and Adjustable-Rate Preferred.

Question 20

What features does straight preferred stock have?

Answer 20

None, There are no special features beyond the stated dividend payment. Missed dividends are not paid to the stockholder.

Question 21

What features do cumulative stock have?

Answer 21

Cumulative stock accrues payments due its shareholders in the event dividends are reduced or suspended. Dividends accrue until the board of directors decides to pay them.

Question 22

What are the feature(s) of Callable Stock?

Answer 22

Callable stock (redeemable) preferred stock can be bought back from investors at a stated price after a specified date.

Question 23

Why would a company want to right to call back, Callable (Redeemable) Stock?

Answer 23

It allows the company to replace a relatively high fixed dividend obligation with a lower one when the cost of money has gone down.

Question 24

What is a convertible stock?

Answer 24

The owner can exchange the shares for a fixed number of shares of common stock of the issuing corporation.

Question 25

What type of stock is it called when the owner can exchange the shares for a fixed number of shares of common stock of the issuing corporation.

Answer 25

Convertible Stock

Question 26

What is an adjustable-rate preferred stock

Answer 26

Preferred stocks issued with adjustable (or variable) dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as monthly.

Question 27

What type of preferred stocks are issued with adjustable (or variable) dividend rates. whose dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as monthly.

Answer 27

Adjustable-Rate Preferred Stock

Question 28

What are some benefits of Owning Preferred Stock

Answer 28

• Fixed income from dividends
• Prior claim ahead of common stock
• Convertible preferred sacrifices income in exchange for potential appreciation

Question 29

What are some risks of Owning Preferred Stock?

Answer 29

• Market risk—in an economic downturn, fear of an inability to maintain the dividend will cause the price to drop
• Possible loss of purchasing power
• Interest rate (money rate) risk
• Business difficulties leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal

Question 30

Do preferred stocks have a preset date at which it matures and scheduled redemption date?

Answer 30

No. although it is generally regarded as a fixed-income investment, preferred stock, unlike debt securities, usually has no preset date at which it matures and no scheduled redemption date. Preferred stock is thus a perpetual security.

Question 31

What two principal kinds of stock option programs are there?

Answer 31

Nonqualified Stock Options (NSO) & Incentive Stock Options (ISO)

Question 32

Describe Nonqualified Stock Options (NSO)?

Answer 32

• More common of the two, the other being Incentive Stock Option (ISO).
• Are treated as form of compensation
• The difference between the current price and the strike price is reported as income.
• Instead of capital gains, it is taxed as ordinary income.

Question 33

What is the bargain element?

Answer 33

When NSOs (Nonqualified Stock Options) are exercised, the difference between the current market price at the time of exercise and the strike price.

Question 34

Describe Incentive Stock Options (ISO)?

Answer 34

An incentive stock option (ISO) gives an employee the right to buy shares of company stock at a discounted price. The profit on qualified ISOs is usually taxed at the capital gains rate, not the higher rate for ordinary income.

Question 35

Between Nonqualified (NSO) & Incentive (ISO) Stock Options, which is subject to alternative minimum tax (AMT)?

Answer 35

Incentive Stock Options

Question 36

What are Restricted Securities?

Answer 36

• retail investors cannot sell these securities until having held them for a certain period of time (generally 6 mos.)
• they are restricted from immediate resale - generally there are volume restrictions.

Question 37

What is Control Stock?

Answer 37

Stock held by a control person - a control person is a corporate director, an officer, a large stockholder, or the immediate family of any of the preceding residing in the same home.

They are generally referred to as affiliates because of their unique status within the issuer.

In general, purchases and sales of control stock must be reported to the SEC. Control stock always has volume limits.

Ownership consisting of 10% or more of the voting stock.

Question 38

Holders of each of the following are creditors except?
A. Investors owning stock
B. Investment companies owning corporate bonds
C. Corporations owning municipal bonds-le bonds
D. State owing U.S. Government bonds

Answer 38

A.

All stockholders (even preferred stockholders), not creditors, are owners of a corporation. When it comes to bonds, regardless of the nature of the owner, it is always a debt security, and that makes the owners creditors.

Question 39

Which of the following statements is regarding rights is true?

A. Common stockholders would not generally receiver preemptive rights.
b. Preferred stockholders would not generally receive preemptive rights.
C. Both common and preferred stockholders would generally receive preemptive rights.
D. Neither common or preferred stockholders would generally receive preemptive rights.

Answer 39

B.

Preferred stockholders have no right to maintain a percentage of ownership when new shares are issues (no preemptive rights). However, they do receive preference in dividend payment and company liquidation.

Question 40

Limited liability regarding ownership in a U.S. corporation means all of the following
except:

A. investors might lose more than the amount of their investment.
B. investors might lose their investment.
C. creditors of the corporation cannot seek relief from the shareholders.
D. investors are not liable to the full extent of their personal property.

Answer 40

A.

An advantage of owning stock is that an investor’s liability is limited to the amount of money invested when the stock was purchased.

Question 41

An investor who has purchased preferred stock with the goal of receiving steady quarterly income would be most interested in the:

A. seniority of the stock compared to other securities.
B. ability of the company to continue paying the stated dividend.
C. voting power of the shares.
D. par value of the shares.

Answer 41

B.

Investors in preferred stock with the goal of income are most concerned that the company will be able to sustain the dividend.

Question 42

An investor owns 15% of the stock of a publicly traded company. This investor’s spouse owns 5% of the stock of the same company. If the spouse wishes to sell the shares representing that 5% ownership, which of the following statements are true?

I. Both the investor and the spouse are control persons.
II. The investor is a control person, while the spouse is not.
III. The spouse must file a Form 144.
IV. The investor must file a Form 144.
A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 42

A.

The investor’s 15% ownership is control. All sales of control stock (unless an exemption applies) must be accompanied by a Rule 144 filing on Form 144 by the selling party. Although both are control persons, the spouse is the only one selling and, therefore, the one required to file.

Question 43

Why type of stock’s price reacts to the market more like a bond because, with its fixed dividend payment, it is price sensitive to interest rate changes.

Answer 43

Preferred stock

Question 44

Of the different types of preferred stock, which would an investor seeking a steady income would find to be most suitable?

Answer 44

Cumulative Preferred Stock

Question 45

For investors looking for fixed income, which type of preferred stock would be their least appropriate choice?

Answer 45

Adjustable-Rate Preferred Stock, because the dividend will likely fluctuate.

Question 46

What is the primary objective when investing in preferred stocks?

Answer 46

Income - when analyzing a specific preferred stock, the most important determination should be the ability of the company to meet its dividend payments.

Question 47

Owners of a corporation’s equity securities:

A. are always assured dividends if the company is profitable.
B. are creditors of the corporation.
C. have limited liability.
D. have the right to vote their shares.

Answer 47

C.

One of the benefits of being an owner of a corporation’s equity securities is limited liability. That means, no matter what happens to the company’s fortunes, the investor can never lose more than the original investment. The company’s creditors cannot come after the stockholders and make a claim. Although owners of common stock always have voting rights, owners of preferred stock (the other equity security) almost never do. Dividends are not guaranteed, and even if the company shows a large profit, there is no obligation to make a dividend payment. Remember, as holder of a company’s equity securities, one is an owner, not a creditor.

Question 48

Among the benefits of owning common stock are:

I. historical hedging against inflation.
II. voting rights.
III. access, as owners, to information about corporate earnings before the general public.
IV. dividends.

A. I and II
B. I, II, and IV
C. II and IV
D. I, II, III, and IV

Answer 48

B.

One does not have access to insider information solely by becoming a shareholder. Even if one did receive material nonpublic information, such as prior access to earnings, no benefit may be received from that information. All of the other choices are among the reasons to purchase common stock.

Question 49

A company that has issued cumulative preferred stock:

A. pays past and current preferred dividends before paying dividends on common stock.
B. pays the preferred dividend before paying the coupons due on its outstanding bonds.
C. pays the current dividends on the preferred, but not the past dividends on the preferred, before paying a dividend on the common.
D. forces conversion of the preferred that is trading at a discount to par, thereby eliminating the need to pay past-due dividends.

Answer 49

A.

The concept behind cumulative preferred stock is that dividends in arrears “accumulate” and must be paid, along with the current year’s dividend, before anything can be paid to common stockholders. Bond interest is always paid before dividends.

Question 50

1. Four years ago, Susan was granted enough nonqualified stock options (NSOs) to purchase 500 shares of her employer’s stock at $20 per share. Assuming Susan exercises all of her options when the fair market value of the stock is $30 per share and her ordinary income tax rate at the time is 28%, how much income tax will be due?

A. $280
B. $1,400
C. $5,600
D. $8,400

Answer 50

B. $1,400.

The exercise cost of the NQSO is $10,000 (500 shares × $20 per share). She will have to pay ordinary income taxes of $1,400 on the bargain element [($30 FMV − $20 exercise price) × 500 shares x 28%]. In addition, that $5,000 bargain element will also be subject to the same payroll taxes as her regular salary (e.g., Social Security tax).

Question 51

Which of the following statements about restricted stock is correct?

A. It must be held a minimum of one year before resale.
B. Sales must be accompanied by Form R.
C. Volume limits generally apply to sales by control (affiliated) persons.
D. The restrictions apply only to those defined as control persons.

Answer 51

C.

All purchasers of restricted stock generally have a holding period requirement of six months, not one year. When reselling that stock, the sale must be accompanied by Form 144. Once the six months is over, nonaffiliated persons have no further restrictions, while control (affiliates) generally have a volume limit.

Question 52

What is an American Depositary Receipt (ADR)?

Answer 52

An ADR is a negotiable security that represents a receipt for shares of stock in a non-U.S. corporation. ADRs are bought and sold in the U.S. securities markets like any domestic stock.

Question 53

Do American Depositary Receipts have voting rights?

Answer 53

No. In some, but not all, cases, there are also voting rights. For purposes of the exam, ADRs never have preemptive rights.

Question 54

What risks are there for ADRs (American Depositary Receipts)?

Answer 54

In addition to the normal risks associated with stock ownership, ADR investors are also subject to currency risk.

Question 55

What is Currency Risk as related to ADRs?

Answer 55

The possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar.

Question 56

How are ADRs issued?

Answer 56

Issued by domestic branches of U.S. banks and that, even though they are traded in U.S. dollars, they still bear currency risk.

Question 57

There are two broad market classifications of foreign markets. What are they?

Answer 57

Emerging and Developed.

Question 58

What are Emerging markets?

Answer 58

Emerging markets are markets in less-developed countries.

Question 59

What are Emerging Markets generally associated with?

Answer 59

• low levels of income, as measured by the
  country’s gross domestic product (GDP);
• low levels of equity capitalization;
• questionable market liquidity;
• potential restrictions on currency
  conversion;
• high volatility;
• prospects for economic growth and
  development;
• stabilizing political and social institutions;
• high taxes and commission costs for
  foreign investors;
• restrictions on foreign ownership and on
  foreign currency conversion; and
• lower regulatory standards resulting in a
  lack of transparency.

Question 60

What is a Frontier Market?

Answer 60

Frontier markets are a country that is more established than the least developed countries (LDCs) but still less established than the emerging markets because it is too small, carries too much inherent risk, or is too illiquid to be considered an emerging market. Frontier markets are also known as pre-emerging markets.

Question 61

What are Developed Markets?

Answer 61

Developed markets are those associated with countries that have highly developed economies with stable political and social institutions.

Question 62

What are Developed Markets characterized by?

Answer 62

• large levels of equity capitalization;
• low commission rates;
• few, if any, currency conversion
  restrictions;
• highly liquid markets with many brokerage
  institutions and market makers;
• many large capitalization securities; and
• well-defined regulatory schemes leading to
  transparency similar to that enjoyed by
  those investing in U.S. securities.

Question 63

What risks are there investing in foreign markets?

Answer 63

• Country risk
• Exchange controls
• Currency risk
• Withholding taxes and fees

Question 64

What is Country Risk?

Answer 64

Is a composite of all the risks of investing in a particular country. These may include political risks (revolutions/military coups); and structural risks (such as confiscatory policies toward profits, capital gains, and dividends). Economic policies, interest rates, and inflation are also elements of risk of investing in emerging countries.

Question 65

ADRs are used to facilitate:

A. foreign trading of domestic securities.
B. foreign trading of U.S. government securities.
C. domestic trading of U.S. government securities.
D. domestic trading of foreign securities.

Answer 65

D.

Because everything is in U.S. dollars and in English, ADRs make trading in foreign
securities much easier for those who live here.

Question 66

2. Which two of the following risks would be of greatest concern to the holder of an ADR?

I. Currency
II. Liquidity
III. Market
IV. Purchasing power

A. I and II
B. I and III
C. II and IV
D. III and IV

Answer 66

B

ADRs represent ownership in a foreign security, so there is always going to be currency risk (I). These ADRs trade in the market and have market risk (III). Because most ADRs are traded on the exchanges, there is little liquidity risk and, because they represent equity, they are usually a good hedge against inflation.