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Exam 20: Hybrid Financing Preferred Stock-Warrants and Convertibles

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Question 1

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Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par?

A) 6.66%
B) 6.99%
C) 7.34%
D) 7.71%
E) 8.09%

F) C) and E)
G) C) and D)

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Question 2

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Which of the following statements is most CORRECT?

A) by law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm's common stock.
B) from the issuer's point of view, preferred stock is less risky than bonds.
C) whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less.
D) unlike bonds, preferred stock cannot have a convertible feature.
E) preferred stock generally has a higher component cost of capital to the firm than does common stock.

F) None of the above
G) B) and E)

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Question 3

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Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible.

Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?

Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost.

Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?

Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: $\begin{array}{lcr}\text { Maturity: } & \text { 10Stock price: } & \$ 30.00 \\\text { Par value: } & \$ 1,000.00 \text { Conversion price: } & \$ 35.00 \\\text { Annual coupon: } & 5.00 \% \text { Straight-debt yield: } & 8.00 \%\end{array}$ -Refer to the data for the Neuman Corporation's convertible bonds. What is the minimum price (or "floor" price) at which the Neuman's bonds should sell?

The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?

Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

The owner of a convertible bond owns, in effect, both a bond and a call option.

Which of the following statements about convertibles is most CORRECT?

A warrant is an option, and as such it cannot be used as a "sweetener."

Which of the following statements concerning warrants is correct?

Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant?

The problem of dilution of stockholders' earnings never results from the sale of call options, but it can arise if warrants are used.

Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: $\begin{array}{lcr}\text { Maturity: } & \text { 10Stock price: } & \$ 30.00 \\\text { Par value: } & \$ 1,000.00 \text { Conversion price: } & \$ 35.00 \\\text { Annual coupon: } & 5.00 \% \text { Straight-debt yield: } & 8.00 \%\end{array}$ -Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's conversion value?

Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters.

Firms generally do not call their convertibles unless the conversion value is greater than the call price.