19

Chapter 19 Convertibles, Warrants, and Derivatives
1. A convertible security is one that can be converted into common stock only at the option of the issuer.
True False
2. A $1,000 par value convertible bond has a conversion ratio of 50. The bond conversion price is $20.
True False
3. The face value of a convertible bond divided by the conversion price equals the number of shares a
bondholder will receive upon conversion.
True False
4. The conversion price divided into the market value of a convertible bond provides the conversion ratio.
True False
5. The conversion premium represents the dollar difference between the conversion value and the pure bond
value.
True False
6. The conversion premium is equal to the market price minus the conversion value.
True False
7. Conversion premiums are found by subtracting the current stock price from the bond's semiannual interest
payment.
True False
8. Conversion premiums are influenced heavily by expectations of future stock performance.
True False
9. Generally, once a convertible bond trades at a certain premium to its intrinsic value, or at a certain multiple
of its conversion price, the bond must be converted into common stock.
True False
1
10. A convertible bond has two separate sources of value, the bond investment value and the bond conversion
value.
True False
11. A convertible bond has both a downside limit (the pure bond value) and an upside limit (the conversion
price).
True False
12. The floor value of a bond can change if market interest rates for competitive bonds change.
True False
13. Convertible securities are attractive because of their downside protection characteristics as well as upside
potential.
True False
14. For the most downside protection, an investor should search for convertibles trading below par value near
their floor value.
True False
15. The downside protection of a convertible bond's floor value insulates the investor from any possible loss.
True False
16. Generally speaking, convertible bonds reverse the risk-return tradeoff that applies to most investments.
True False
17. The interest rate on convertible bonds is typically one-third higher than similar non-convertible issues.
True False
18. If you purchased a convertible bond when first issued, you would pay more for the shares of stock you are
entitled to than if you purchased the shares directly on the market at that point in time.
True False
19. The primary issuers of convertible bonds are smaller, less than top-grade companies.
True False
2
20. In general the average size of convertible issues is small compared to normal bond issues.
True False
21. On average, convertible bonds have conversion premiums of less than 10% at time of issue.
True False
22. A call provision is a commonly used device by a corporation to force conversion into common stock.
True False
23. Forced conversion refers to the corporation calling a convertible bond when the market price of the stock is
above the conversion price by more than a small percentage.
True False
24. A forced conversion will alter the corporate balance sheet.
True False
25. On average, convertible bonds have call premiums of less than 10% at time of issue.
True False
26. Basic earnings per share includes all convertible bonds outstanding.
True False
27. Basic earnings per share does not include the dilutive effects of all of a firm's convertible bonds.
True False
28. Diluted earnings per share must include all convertible securities.
True False
29. In order to calculate basic earnings per share, the earnings after taxes have to be adjusted for the
elimination of the convertible bond interest expense.
True False
3
30. Warrants never sell for more than their intrinsic value.
True False
31. A warrant may carry a speculative premium above intrinsic value if it will not expire until far into the
future.
True False
32. Because a warrant is dependent on the market movement of an underlying stock, it is highly speculative in
nature.
True False
33. Warrants are often attached to debt securities to increase the debt issue's attractiveness to investors.
True False
34. The premium for a warrant would increase if its underlying common stock has a negative market outlook.
True False
35. A warrant's speculative premium equals the market price of the underlying common stock minus the option
price.
True False
36. A warrant loses some of its financial leverage when the stock rises far above the exercise price.
True False
37. As a financing device for creating common stock, warrants are usually more desirable than convertible
bonds.
True False
38. Warrants are considered only in the computation of diluted earnings per share.
True False
39. Theoretically, stock options are granted to employees so that the employees will make decisions that
benefit shareholders.
True False
4
40. Most corporations include call provisions in agreements relating to the issue of warrants.
True False
41. Forced conversions of convertible bonds occur when unethical corporate executives call corporate bonds
prematurely.
True False
42. Convertible bonds and convertible preferred stock are used on a regular basis by corporations to diversify
their capital structure.
True False
43. The conversion value is equal to the conversion ratio times the conversion price.
True False
44. When the market price of a common stock rises above the conversion price, the convertible should always
be converted immediately before it drops.
True False
45. The conversion premium of a convertible is generally greater when the market price of the stock is below
the conversion price.
True False
46. Convertible bonds offer minimal risk of loss to the investor due to their floor value.
True False
47. Investors will generally choose the call price rather than the shares of stock during a forced conversion.
True False
48. A convertible security is almost always
A. a security that can be converted into any other type of security.

B. a debt security that can only be converted into preferred stock.
C. a security that can be converted into common stock at the holder's option.
D. a security that can be converted into common stock only at the option of the issuing corporation.
5
49. A convertible bond is currently selling for $970. It is convertible into 15 shares of common which presently
sell for $50 per share. The conversion premium is
A. $90
B. $220
C. 57 shares
D. 13 shares
50. If the price of common stock associated with a convertible bond is less than the conversion price
A. the bond will sell at its pure bond value.

B. the bond will sell at its par value.
C. the bond will sell at its conversion value.
D. there is not enough information to tell what the bond price will be.
51. The conversion ratio is the
A. price at which a convertible security is exchanged into common stock.

B. ratio of conversion value to market value of a convertible security.
C. number of shares of common stock into which the convertible may be converted.
D. ratio of the conversion premium to market value of a convertible security.
52. The conversion premium will be large
A. if investors have great expectations for the price of the common stock.
B. if interest rates decline.
C. when the conversion value is much greater than the pure bond value.
D. when the stock price is very stable.
53. Which of the following is true?
A. As the price of common stock increases, the market price of a convertible bond and the conversion
premium increase.
B. As the price of common stock increases, the market price of a convertible bond and the conversion value
increase.
C. As the price of common stock increases, the conversion value and the floor price increase.
D. Two of the above are true.
6
54. Expectations of a significant increase in the price of a firm's common stock will result in
A. large conversion premiums for the firm's convertible bonds.

B. small conversion premiums for the firm's convertible bonds.
C. negative conversion premiums for the firm's convertible bonds.
D. no effect at all on conversion premiums.
55. A convertible bond is currently selling for $1,125. It is convertible into 20 shares of common which
presently sell for $40 per share. The conversion premium is
A. $325
B. $215
C. 66.74 shares
D. 23.8 shares
56. A $1,000 par value bond with a conversion price of $50 has a conversion ratio of
A. $40
B. 40 shares
C. $20
D. 20 shares
57. The theoretical floor value for a convertible bond is its
A. conversion price.
B. conversion value.
C. par value.
D. pure bond value.
58. The floor price of a convertible bond cannot fall below
A. the conversion ratio.

B. the conversion price.
C. the conversion premium.
D. the pure bond value.
7
59. The price of a convertible bond
A. has downside as well upside limitations.

B. has only upside limitations.
C. has only downside limitations.
D. has no upside or downside limitations.
60. The conversion premium is the greatest and the downside risk the smallest when
A. the conversion value equals the pure bond value.

B. the conversion value is greater than the pure bond value.
C. the conversion value is less than the pure bond value.
D. the stock price is expected to go up drastically.
61. The "floor" or pure bond value of a convertible bond is found by
A. multiplying the price of the firm's common stock by the conversion ratio.
B. multiplying the bond's conversion premium by the price of the firm's common stock.
C. multiplying the price of the firm's common stock by the conversion ratio and adding the present value of
the bond's face value.
D. finding the present value of the bond's interest payments and adding the present value of the bond's face
value.
62. The interest rate on convertibles is generally ____________ the interest rate on similar nonconvertible
instruments.
A. greater than
B. less than
C. the same as
D. at least twice
63. A convertible bond is often utilized
A. as a sweetener when selling debt.

B. to sell common at prices higher than those prevailing when funds are needed.
C. when there is no demand for straight debt.
D. All of these.
8
64. A disadvantage to the investor of a convertible bond is that
A. the stock price may never rise above conversion price.

B. if interest rates rise, the pure bond value (floor price) will decline.
C. the interest rate on convertibles is generally one-third below the coupon rate on straight bonds of similar
risk.
D. all of these are disadvantages.
65. Conversion price is usually set _______ the prevailing market price of the common stock at the time the
bond issue is sold.
A. at
B. below
C. above
D. one half
66. Which of the following is not a characteristic of convertible bond issues?
A. The average size of the offering is small.

B. A 15-20% conversion premium at time of issue is common.
C. Large companies with billions of dollars in sales and assets are the primary issuers.
D. Primary issuers tend to have less than AAA credit ratings.
67. If the stock price rises substantially above the conversion price, an advantage to the corporation would be
A. the premium would decrease.

B. the floor price would offer the investor downside protection.
C. the bond would most likely be converted into common stock and the debt would not have to be repaid.
D. none of these are advantages to the corporation.
68. One advantage to the corporation in selling a convertible bond is:
A. the interest rate on a convertible is lower than a straight debt issue of equal risk.
B. the bond may never get converted into common stock and create dilution.
C. if interest rates fall the bond is likely to be refunded.
D. all of these.
9
69. Which of the following characteristics are drawbacks of convertible bonds?
A. Downside protection is ineffectual if the bond is bought at a large premium over floor value.
B. Interest rates on the debt-instrument part of a convertible bond are frequently below market interest
rates.
C. Conversion may be forced on the bondholder by call provisions on the convertible bond.
D. All of these are drawbacks of convertibles.
70. The principle device used by the corporation to force conversion
A. is setting the conversion price above the current market price.

B. is reducing the amount of interest payments.
C. is buying bonds back at below par value.
D. is a call provision.
71. When a company has a convertible bond in its capital structure,
A. it can reduce its debt-to-equity ratio by calling the bond.

B. there is no effect on the firm's earnings per share.
C. there is no advantage to the firm in forcing conversion of the bonds.
D. all of these.
72. A step-up in the conversion price refers to
A. the ability of the company to step up the maturity of the bond to an earlier date.
B. the provision that decreases the conversion ratio the longer a convertible bond is held.
C. a refunding of a convertible bond when the conversion value equals the pure bond value.
D. none of these.
73. The computation of basic earnings per share will include consideration of
A. all convertible securities.

B. only shares outstanding.
C. shares outstanding and convertible securities.
D. none of these.
10
74. Mirrlees Corp. has 10,000 7% bonds convertible into 30 shares per $1000 bond. Mirrlees has 1,000,000
outstanding shares. Mirrlees has a tax rate of 40%. The average Aa bond yield at time of issue was 10%.
Compute basic earnings per share if after-tax earnings are $1,400,000.
A. $0.71
B. $1.25
C. $1.33
D. $1.40
75. Vickrey Technology has had net income of $1,500,000 in the current fiscal year. There are 1,000,000
shares of common stock outstanding along with convertible bonds, which have a total face value of $8
million. The $8 million is represented by 5,000 different $1,000 bonds. Each $1,000 bond pays 4 percent
interest. The conversion ratio is 30. The firm is in a 30 percent tax bracket. What is Vickrey's diluted
earnings per share?
A. $1.43
B. $1.81
C. $2.00
D. None of these
76. Jacobs and Company has warrants outstanding, which are selling at a $2.50 premium above intrinsic value.
Each warrant allows its owner to purchase one share of common stock at $26. If the common stock
currently sells for $30, what is the warrant price?
A. $6.40
B. $6.75
C. $7.25
D. $6.50
77. Which of the following is true about warrants?
A. At high stock prices, the warrant premium is high.

B. A rising stock price is usually followed by an increase in the price of the warrant.
C. a and b are true.
D. None of these are true.
11
78. The Burma Hat Company's warrant is trading for $10.20. The warrant carries the option to purchase two
shares of common stock for $48. What is the speculative premium if the stock price is $51.30?
A. $3.30
B. $3.60
C. $6.60
D. None of these.
79. Warrants are
A. long-term options to sell shares of the issuing firm's stock.

B. fairly stable, low-risk investments.
C. investments whose value is directly related to the price of the underlying stock.
D. structured to sell for precisely their intrinsic value.
80. The intrinsic value of a warrant to buy 4 shares of Merton stock at $53 per share is $20. What is the current
market price of Merton stock?
A. $55.00
B. $59.00
C. $58.00
D. None of these
81. The Rocky Scholes Swimwear's warrant is trading for $10.00. The warrant carries the option to purchase a
half share of common stock for $50. What is the speculative premium if the stock price is $65?
A. $1.00
B. $2.50
C. $5.00
D. None of these.
12
82. Sen Corporation warrants carry the right to buy 10 shares of Sen common stock at $11.00 per share. The
common stock has a current market price of $11.75 per share. The intrinsic or minimum value of one Sen
warrant is
A. $0
B. $1.50
C. $15
D. $7.50
83. A warrant which does not expire until several years in the future which provides its owner the opportunity
to buy a stock. If the stock price rises, the warrant will probably sell for
A. less than its intrinsic value.

B. exactly its intrinsic value.
C. more than its intrinsic value.
D. less than or equal to its intrinsic value.
84. A contract giving the owner the right to buy or sell an asset at a fixed price for a given period of time is
A. a common stock.
B. an option.
C. a futures.
D. a capital investment.
85. A derivative is a financial instrument whose value is determined by
A. a regulatory body such as the SEC.

B. an underlying security.
C. futures and options.
D. None of these.
86. Options contracts contrast with futures because
A. options are not traded on organized exchanges.

B. options do create an obligation for the owner of the instrument.
C. options are derivatives.
D. None of these.
13
87. The owner of a call has
A. the right and the obligation to buy an asset at a given price.

B. the right and the obligation to sell an asset at a given price.
C. the right but not the obligation to buy an asset at a given price.
D. the right but not the obligation to sell an asset at a given price.
88. The owner of a put has

89. Which contract is an option?
A. A call
B. A put
C. A future
D. Both A and B are options
90. All of the following are advantages to the corporation of issuing convertibles except:
A. provides a low-cost financing alternative for large, high-quality companies

B. used when believe stock is undervalued
C. generally lower cost than straight debt
D. provides access for small co's to debt market
91. The following benefits occur to the corporation after forced conversion of a convertible bond except
A. Lower times interest earned

B. Lower debt to asset ratio
C. Higher earnings after taxes
D. All of these are benefits
14
92. All of the following are motivation for firms to issue warrants except:
A. may allow the firm to issue debt at lower rate when warrants are included
B. used as sweetener during merger negotiations
C. more desirable than convertible securities for creating new common stock
D. all of these are motivations
93. Match the following with the items below:
1. convertible May be traded in to the company for a different

security form of security. ____
Sometimes used as a financial sweetener in a bond
2. warrant offering. ____
The number of shares an investor will receive if he
or she exchanges a convertible bond for common
3. floor price stock. ____
The value of a convertible bond if its present value
was computed at a discount rate equal to interest rates
4. conversion on straight bonds of equal risk without conversion
ratio privileges. ____
The right to buy an asset for a given time at a
5. a call specified price. ____
6. conversion Equals the conversion ratio multiplied by the
value market price per share of common stock. ____
7. step-up in
conversion price Is usually equal to the pure bond value. ____
8. pure bond Equals earnings after taxes divided by shares
value outstanding. ____
9. basic earnings This feature, when written into the contract, allows
per share the conversion ratio to decline over time. ____
10. forced Occurs when a company calls a convertible security
conversion that has a conversion value greater than the call price. ____
15
1. conversion Equals the conversion ratio divided into the par

premium value. ____
Equals the market price of a convertible bond
2. warrant minus the security's theoretical value. ____
Adjusts earnings per share for potential share
3. speculative issuances related to outstanding options, convertible
warrant premium securities and warrants. ____
4. conversion May be exchanged with the company, usually for
price shares of common stock. ____
Equals the market value of the common stock
minus the option price of the warrant all multiplied by
5. financial the number of shares each warrant entitles the holder
sweetener to purchase. ____
6. minimum The market price of the warrant minus the
warrant value warrant's intrinsic value. ____
7. diluted earnings May be used as a means to offer lower interest
per share rates on debt. ____
8. convertible The use of an equity option to facilitate sale of a
security debt security. ____
The right to sell an asset for a given time at a
9. put option specified price. ____
16
95. Lucky Dog Pet Food has a $1000 convertible bond outstanding with a conversion price of $12.00 per share.
The bond pays an interest payment of $40 semiannually and matures in 20 years unless converted into
common stock earlier or called by the company. The common stock currently sells for $11.25 per share. If
the bond sold at its theoretical bond value it would be priced competitively to yield 10% with bonds of the
same risk class.
a) How many shares of stock are received on conversion?
b) What is the conversion value?
c) What is the pure bond value?
d) How much downside protection has the pure bond value provided to investors? (answer in dollars)
96. The Whipple Corporation currently has common stock selling for $40 per share on the National Stock
Exchange. Warrants are also available entitling the warrant holder the option of purchasing 1 share of
common stock for every 3 warrants held. The exercise price is $32 per share. The warrants are currently
selling for $7 per warrant.
a) How much would you have to spend to buy one share of stock using the warrants? Does this make
sense?
b) What is the intrinsic value of the warrant?
c) What is the speculative premium on this warrant?
17
97. The XLarge Corporation has a convertible bond outstanding with a conversion price of $35 per share. The
$1000 par value bonds have a 6% annual coupon rate, paid semi-annually, and 20 years to maturity. The
firm's common stock is currently selling for $44 per share and the convertible bonds are selling for
$1,200.00.
a) Calculate the conversion ratio.
b) Calculate the conversion value.
c) If equivalent bonds are currently yielding 12% to maturity, what is the pure bond value of this bond?
d) How much downside protection does the pure bond value provide to an investor? Would this be an
appropriate investment for a risk-averse investor?
98. Fred Jury is a portfolio manager who has $900,000 of a client's money to invest in highly speculative
instruments. Jury is contemplating the purchase of 40,000 shares of Shakee Corp. common stock, which is
currently selling on the American Stock Exchange at $30.00 per share. Alternatively, he could buy warrants
on Shakee Corp. common for $5.50. Each warrant gives the holder the right to buy one share of Shakee
Corp. common stock at $24.00 per share.
a) How many warrants could Mr. Jury buy with the $900,000?
b) If he had purchased the common stock directly, and its price had increased to $37.20 per share, calculate
his dollar and percentage return on the investment.
c) Assume that when the price of the stock goes to $37.20 per share, the warrant sells for its intrinsic value.
If Jury sells his warrants at this point, calculate his dollar and percentage return on the investment.
18
19 Key
1. A convertible security is one that can be converted into common stock only at the option of the issuer.
FALSE
Block - Chapter 19 #1
Blooms: Remember
Difficulty: Basic
Learning Objective: 19-01 Convertible securities can be converted to common stock at the option of the owner.
2. A $1,000 par value convertible bond has a conversion ratio of 50. The bond conversion price is $20.
TRUE
Blooms: Analytic
Blooms: Apply
Difficulty: Basic
Learning Objective: 19-02 Because these securities can be converted to common stock; they may move with the value of common stock.
3. The face value of a convertible bond divided by the conversion price equals the number of shares a
bondholder will receive upon conversion.
TRUE
Blooms: Remember
Difficulty: Basic
4. The conversion price divided into the market value of a convertible bond provides the conversion ratio.
FALSE
Blooms: Remember
Difficulty: Basic
5. The conversion premium represents the dollar difference between the conversion value and the pure
bond value.
FALSE
Blooms: Remember
Difficulty: Basic
19
6. The conversion premium is equal to the market price minus the conversion value.
TRUE
Blooms: Remember
Difficulty: Basic
7. Conversion premiums are found by subtracting the current stock price from the bond's semiannual
interest payment.
FALSE
Blooms: Remember
Difficulty: Basic
8. Conversion premiums are influenced heavily by expectations of future stock performance.
TRUE
Blooms: Remember
Difficulty: Intermediate
9. Generally, once a convertible bond trades at a certain premium to its intrinsic value, or at a certain
multiple of its conversion price, the bond must be converted into common stock.
FALSE
Blooms: Remember
10. A convertible bond has two separate sources of value, the bond investment value and the bond
conversion value.
TRUE
Blooms: Remember
Difficulty: Basic
Learning Objective: 19-03 Convertible bonds have a pure bond value based on interest paid.
20
11. A convertible bond has both a downside limit (the pure bond value) and an upside limit (the conversion
price).
FALSE
Blooms: Remember
12. The floor value of a bond can change if market interest rates for competitive bonds change.
TRUE

Blooms: Remember
13. Convertible securities are attractive because of their downside protection characteristics as well as
upside potential.
TRUE

Blooms: Remember
Difficulty: Basic
14. For the most downside protection, an investor should search for convertibles trading below par value
near their floor value.
TRUE
Blooms: Analytic
Blooms: Evaluate
15. The downside protection of a convertible bond's floor value insulates the investor from any possible
loss.
FALSE
Blooms: Understand
21
16. Generally speaking, convertible bonds reverse the risk-return tradeoff that applies to most investments.
FALSE

Blooms: Remember
17. The interest rate on convertible bonds is typically one-third higher than similar non-convertible issues.
FALSE

Blooms: Remember
Difficulty: Basic
18. If you purchased a convertible bond when first issued, you would pay more for the shares of stock you
are entitled to than if you purchased the shares directly on the market at that point in time.
TRUE

Blooms: Analytic
Blooms: Evaluate
19. The primary issuers of convertible bonds are smaller, less than top-grade companies.
TRUE

Blooms: Remember
20. In general the average size of convertible issues is small compared to normal bond issues.
TRUE
Blooms: Remember
21. On average, convertible bonds have conversion premiums of less than 10% at time of issue.
FALSE
22
Blooms: Remember
22. A call provision is a commonly used device by a corporation to force conversion into common stock.
TRUE
Blooms: Remember
Difficulty: Basic
23. Forced conversion refers to the corporation calling a convertible bond when the market price of the
stock is above the conversion price by more than a small percentage.
TRUE
Blooms: Remember
24. A forced conversion will alter the corporate balance sheet.
TRUE
Blooms: Remember
Learning Objective: 19-05 Accountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement.
Accountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement.
25. On average, convertible bonds have call premiums of less than 10% at time of issue.
TRUE
Blooms: Remember
26. Basic earnings per share includes all convertible bonds outstanding.
FALSE

Blooms: Remember
Difficulty: Basic
23
27. Basic earnings per share does not include the dilutive effects of all of a firm's convertible bonds.
TRUE

Blooms: Remember
28. Diluted earnings per share must include all convertible securities.
TRUE

Blooms: Remember
29. In order to calculate basic earnings per share, the earnings after taxes have to be adjusted for the
elimination of the convertible bond interest expense.
FALSE
Blooms: Remember
30. Warrants never sell for more than their intrinsic value.
FALSE
Blooms: Remember
Difficulty: Basic
Learning Objective: 19-04 Warrants are similar to convertibles in that they give the warrant holder the right to acquire common stock.
31. A warrant may carry a speculative premium above intrinsic value if it will not expire until far into the
future.
TRUE
Blooms: Remember
24
32. Because a warrant is dependent on the market movement of an underlying stock, it is highly speculative
in nature.
TRUE
Blooms: Remember
33. Warrants are often attached to debt securities to increase the debt issue's attractiveness to investors.
TRUE

Blooms: Remember
Difficulty: Basic
34. The premium for a warrant would increase if its underlying common stock has a negative market
outlook.
FALSE

Blooms: Understand
35. A warrant's speculative premium equals the market price of the underlying common stock minus the
option price.
FALSE

Blooms: Remember
36. A warrant loses some of its financial leverage when the stock rises far above the exercise price.
TRUE
Blooms: Remember
25
37. As a financing device for creating common stock, warrants are usually more desirable than convertible
bonds.
FALSE
Blooms: Remember
38. Warrants are considered only in the computation of diluted earnings per share.
TRUE

Blooms: Remember
39. Theoretically, stock options are granted to employees so that the employees will make decisions that
benefit shareholders.
TRUE
AACSB: Ethics (ethical understanding and reasoning)

Blooms: Remember
Difficulty: Basic
40. Most corporations include call provisions in agreements relating to the issue of warrants.
FALSE

Blooms: Remember
Difficulty: Basic
41. Forced conversions of convertible bonds occur when unethical corporate executives call corporate
bonds prematurely.
FALSE
AACSB: Ethics (ethical understanding and reasoning)

Blooms: Understand
26
42. Convertible bonds and convertible preferred stock are used on a regular basis by corporations to
diversify their capital structure.
FALSE
Blooms: Understand
43. The conversion value is equal to the conversion ratio times the conversion price.
FALSE

Blooms: Understand
44. When the market price of a common stock rises above the conversion price, the convertible should
always be converted immediately before it drops.
FALSE

Blooms: Analytic
Blooms: Evaluate
45. The conversion premium of a convertible is generally greater when the market price of the stock is
below the conversion price.
TRUE
Blooms: Analytic
Blooms: Evaluate
46. Convertible bonds offer minimal risk of loss to the investor due to their floor value.
FALSE

Blooms: Analytic
Blooms: Evaluate
27
47. Investors will generally choose the call price rather than the shares of stock during a forced conversion.
FALSE

Blooms: Analytic
Blooms: Evaluate
48. A convertible security is almost always
A. a security that can be converted into any other type of security.

B. a debt security that can only be converted into preferred stock.
C. a security that can be converted into common stock at the holder's option.
D. a security that can be converted into common stock only at the option of the issuing corporation.

Blooms: Understand
49. A convertible bond is currently selling for $970. It is convertible into 15 shares of common which
A. $90
B. $220
C. 57 shares
D. 13 shares
$50 stock price x 15 shares = $750 conversion value

Conversion premium = Bond price of $970 - Conversion value of $750 = $220

Blooms: Analytic
Blooms: Apply
Difficulty: Basic
28
50. If the price of common stock associated with a convertible bond is less than the conversion price
A. the bond will sell at its pure bond value.

B. the bond will sell at its par value.
C. the bond will sell at its conversion value.
D. there is not enough information to tell what the bond price will be.

Blooms: Understand
Difficulty: Basic
51. The conversion ratio is the
A. price at which a convertible security is exchanged into common stock.

B. ratio of conversion value to market value of a convertible security.
C. number of shares of common stock into which the convertible may be converted.
D. ratio of the conversion premium to market value of a convertible security.

Blooms: Remember
52. The conversion premium will be large
A. if investors have great expectations for the price of the common stock.
B. if interest rates decline.
C. when the conversion value is much greater than the pure bond value.
D. when the stock price is very stable.

Blooms: Remember
Difficulty: Basic
29
53. Which of the following is true?
A. As the price of common stock increases, the market price of a convertible bond and the conversion
premium increase.
B. As the price of common stock increases, the market price of a convertible bond and the conversion
value increase.
C. As the price of common stock increases, the conversion value and the floor price increase.
D. Two of the above are true.

Blooms: Analytic
Blooms: Analyze
Difficulty: Challenge
54. Expectations of a significant increase in the price of a firm's common stock will result in
A. large conversion premiums for the firm's convertible bonds.

B. small conversion premiums for the firm's convertible bonds.
C. negative conversion premiums for the firm's convertible bonds.
D. no effect at all on conversion premiums.

Blooms: Understand
55. A convertible bond is currently selling for $1,125. It is convertible into 20 shares of common which
A. $325
B. $215
C. 66.74 shares
D. 23.8 shares
$40 stock price x 20 shares = $800 conversion value

Conversion premium = Bond price of $1,125 - Conversion value of $800 = $325

Blooms: Analytic
Blooms: Apply
Difficulty: Basic
30
56. A $1,000 par value bond with a conversion price of $50 has a conversion ratio of
A. $40
B. 40 shares
C. $20
D. 20 shares
Conversion ratio = Par value of $1,000/Conversion price of $50 = 20 shares

Blooms: Analytic
Blooms: Apply
Difficulty: Basic
57. The theoretical floor value for a convertible bond is its
A. conversion price.
B. conversion value.
C. par value.
D. pure bond value.

Blooms: Remember
Difficulty: Basic
58. The floor price of a convertible bond cannot fall below
A. the conversion ratio.

B. the conversion price.
C. the conversion premium.
D. the pure bond value.

Blooms: Remember
Difficulty: Basic
31
59. The price of a convertible bond
A. has downside as well upside limitations.

B. has only upside limitations.
C. has only downside limitations.
D. has no upside or downside limitations.

Blooms: Understand
Difficulty: Basic
60. The conversion premium is the greatest and the downside risk the smallest when
A. the conversion value equals the pure bond value.

B. the conversion value is greater than the pure bond value.
C. the conversion value is less than the pure bond value.
D. the stock price is expected to go up drastically.

Blooms: Understand
61. The "floor" or pure bond value of a convertible bond is found by
A. multiplying the price of the firm's common stock by the conversion ratio.
B. multiplying the bond's conversion premium by the price of the firm's common stock.
C. multiplying the price of the firm's common stock by the conversion ratio and adding the present
value of the bond's face value.
D. finding the present value of the bond's interest payments and adding the present value of the bond's
face value.

Blooms: Remember
32
62. The interest rate on convertibles is generally ____________ the interest rate on similar nonconvertible
instruments.
A. greater than
B. less than
C. the same as
D. at least twice

Blooms: Remember
Difficulty: Basic
63. A convertible bond is often utilized
A. as a sweetener when selling debt.

B. to sell common at prices higher than those prevailing when funds are needed.
C. when there is no demand for straight debt.
D. All of these.

Blooms: Remember
Difficulty: Basic
64. A disadvantage to the investor of a convertible bond is that
A. the stock price may never rise above conversion price.

B. if interest rates rise, the pure bond value (floor price) will decline.
C. the interest rate on convertibles is generally one-third below the coupon rate on straight bonds of
similar risk.
D. all of these are disadvantages.

Blooms: Remember
33
65. Conversion price is usually set _______ the prevailing market price of the common stock at the time the
bond issue is sold.
A. at
B. below
C. above
D. one half

Blooms: Remember
66. Which of the following is not a characteristic of convertible bond issues?
A. The average size of the offering is small.

B. A 15-20% conversion premium at time of issue is common.
C. Large companies with billions of dollars in sales and assets are the primary issuers.
D. Primary issuers tend to have less than AAA credit ratings.

Blooms: Remember
67. If the stock price rises substantially above the conversion price, an advantage to the corporation would
be
A. the premium would decrease.

B. the floor price would offer the investor downside protection.
C. the bond would most likely be converted into common stock and the debt would not have to be
repaid.
D. none of these are advantages to the corporation.

Blooms: Remember
Difficulty: Basic
34
68. One advantage to the corporation in selling a convertible bond is:
A. the interest rate on a convertible is lower than a straight debt issue of equal risk.
B. the bond may never get converted into common stock and create dilution.
C. if interest rates fall the bond is likely to be refunded.
D. all of these.

Blooms: Remember
69. Which of the following characteristics are drawbacks of convertible bonds?
A. Downside protection is ineffectual if the bond is bought at a large premium over floor value.
B. Interest rates on the debt-instrument part of a convertible bond are frequently below market interest
rates.
C. Conversion may be forced on the bondholder by call provisions on the convertible bond.
D. All of these are drawbacks of convertibles.

Blooms: Remember
70. The principle device used by the corporation to force conversion
A. is setting the conversion price above the current market price.

B. is reducing the amount of interest payments.
C. is buying bonds back at below par value.
D. is a call provision.

Blooms: Remember
Difficulty: Basic
35
71. When a company has a convertible bond in its capital structure,
A. it can reduce its debt-to-equity ratio by calling the bond.

B. there is no effect on the firm's earnings per share.
C. there is no advantage to the firm in forcing conversion of the bonds.
D. all of these.

Blooms: Understand
72. A step-up in the conversion price refers to
A. the ability of the company to step up the maturity of the bond to an earlier date.
B. the provision that decreases the conversion ratio the longer a convertible bond is held.
C. a refunding of a convertible bond when the conversion value equals the pure bond value.
D. none of these.

Blooms: Remember
Difficulty: Basic
73. The computation of basic earnings per share will include consideration of
A. all convertible securities.

B. only shares outstanding.
C. shares outstanding and convertible securities.
D. none of these.

Blooms: Remember
Difficulty: Basic
36
74. Mirrlees Corp. has 10,000 7% bonds convertible into 30 shares per $1000 bond. Mirrlees has 1,000,000
outstanding shares. Mirrlees has a tax rate of 40%. The average Aa bond yield at time of issue was 10%.
Compute basic earnings per share if after-tax earnings are $1,400,000.
A. $0.71
B. $1.25
C. $1.33
D. $1.40
After-tax earnings of $1,400,000/1,000,000 shares = $1.40 earnings per share

Blooms: Analytic
Blooms: Apply
75. Vickrey Technology has had net income of $1,500,000 in the current fiscal year. There are 1,000,000
shares of common stock outstanding along with convertible bonds, which have a total face value of $8
million. The $8 million is represented by 5,000 different $1,000 bonds. Each $1,000 bond pays 4
percent interest. The conversion ratio is 30. The firm is in a 30 percent tax bracket. What is Vickrey's
diluted earnings per share?
A. $1.43
B. $1.81
C. $2.00
D. None of these

Blooms: Analytic
Blooms: Apply
37
76. Jacobs and Company has warrants outstanding, which are selling at a $2.50 premium above intrinsic
value. Each warrant allows its owner to purchase one share of common stock at $26. If the common
stock currently sells for $30, what is the warrant price?
A. $6.40
B. $6.75
C. $7.25
D. $6.50
($30 Stock price - $26 Exercise price) x 1 share = $4.00 intrinsic value
Warrant price - $4.00 Intrinsic value = $2.50 Speculative premium
Warrant price = $6.50

Blooms: Analytic
Blooms: Apply
77. Which of the following is true about warrants?
A. At high stock prices, the warrant premium is high.

B. A rising stock price is usually followed by an increase in the price of the warrant.
C. a and b are true.
D. None of these are true.

Blooms: Analytic
Blooms: Analyze
78. The Burma Hat Company's warrant is trading for $10.20. The warrant carries the option to purchase two
shares of common stock for $48. What is the speculative premium if the stock price is $51.30?
A. $3.30
B. $3.60
C. $6.60
D. None of these.

Blooms: Analytic
Blooms: Apply
38
79. Warrants are
A. long-term options to sell shares of the issuing firm's stock.

B. fairly stable, low-risk investments.
C. investments whose value is directly related to the price of the underlying stock.
D. structured to sell for precisely their intrinsic value.

Blooms: Remember
Difficulty: Basic
80. The intrinsic value of a warrant to buy 4 shares of Merton stock at $53 per share is $20. What is the
current market price of Merton stock?
A. $55.00
B. $59.00
C. $58.00
D. None of these
(Stock price - Exercise price) x 4 shares = $20.00 Intrinsic value

(Stock price - $53.00) x 4 = $20.00 Speculative premium
Stock price = $58.00

Blooms: Analytic
Blooms: Apply
39
81. The Rocky Scholes Swimwear's warrant is trading for $10.00. The warrant carries the option to
purchase a half share of common stock for $50. What is the speculative premium if the stock price is
$65?
A. $1.00
B. $2.50
C. $5.00
D. None of these.
($65 Stock price - $50 Exercise price) x ½ share = $7.50 intrinsic value
$10 warrant price - $7.50 Intrinsic value = $2.50 Speculative premium

Blooms: Analytic
Blooms: Apply
82. Sen Corporation warrants carry the right to buy 10 shares of Sen common stock at $11.00 per share. The
common stock has a current market price of $11.75 per share. The intrinsic or minimum value of one
Sen warrant is
A. $0
B. $1.50
C. $15
D. $7.50
($11.75 Stock price - $11.00 Exercise price) x 10 shares = $7.50 intrinsic value

Blooms: Analytic
Blooms: Apply
40
83. A warrant which does not expire until several years in the future which provides its owner the
opportunity to buy a stock. If the stock price rises, the warrant will probably sell for
A. less than its intrinsic value.

B. exactly its intrinsic value.
C. more than its intrinsic value.
D. less than or equal to its intrinsic value.

Blooms: Understand
84. A contract giving the owner the right to buy or sell an asset at a fixed price for a given period of time is
A. a common stock.
B. an option.
C. a futures.
D. a capital investment.

Blooms: Remember
Difficulty: Basic
Learning Objective: 19-06 Derivative securities such as options and futures can be used by corporate financial managers for hedging activities. Derivative securities
such as options and futures can be used by corporate financial managers for hedging activities.
85. A derivative is a financial instrument whose value is determined by
A. a regulatory body such as the SEC.

B. an underlying security.
C. futures and options.
D. None of these.

Blooms: Remember
Difficulty: Basic
Learning Objective: 19-06 Derivative securities such as options and futures can be used by corporate financial managers for hedging activities.
41
86. Options contracts contrast with futures because
A. options are not traded on organized exchanges.

B. options do create an obligation for the owner of the instrument.
C. options are derivatives.
D. None of these.

Blooms: Remember
Difficulty: Basic
87. The owner of a call has


Blooms: Remember
Difficulty: Basic
88. The owner of a put has


Blooms: Remember
Difficulty: Basic
89. Which contract is an option?
A. A call
B. A put
C. A future
D. Both A and B are options
42
Blooms: Remember
Difficulty: Basic
90. All of the following are advantages to the corporation of issuing convertibles except:
A. provides a low-cost financing alternative for large, high-quality companies

B. used when believe stock is undervalued
C. generally lower cost than straight debt
D. provides access for small co's to debt market

Blooms: Understand
91. The following benefits occur to the corporation after forced conversion of a convertible bond except
A. Lower times interest earned

B. Lower debt to asset ratio
C. Higher earnings after taxes
D. All of these are benefits

Blooms: Analytic
Blooms: Analyze
92. All of the following are motivation for firms to issue warrants except:
A. may allow the firm to issue debt at lower rate when warrants are included
B. used as sweetener during merger negotiations
C. more desirable than convertible securities for creating new common stock
D. all of these are motivations

Blooms: Analytic
Blooms: Analyze
43
1. convertible May be traded in to the company for a different

security form of security. 1
Sometimes used as a financial sweetener in a bond
2. warrant offering. 2
The number of shares an investor will receive if he
or she exchanges a convertible bond for common
3. floor price stock. 4
The value of a convertible bond if its present value
was computed at a discount rate equal to interest rates
4. conversion on straight bonds of equal risk without conversion
ratio privileges. 8
The right to buy an asset for a given time at a
5. a call specified price. 5
6. conversion Equals the conversion ratio multiplied by the
value market price per share of common stock. 6
7. step-up in
conversion price Is usually equal to the pure bond value. 3
8. pure bond Equals earnings after taxes divided by shares
value outstanding. 9
9. basic earnings This feature, when written into the contract, allows
per share the conversion ratio to decline over time. 7
10. forced Occurs when a company calls a convertible security
conversion that has a conversion value greater than the call price. 10

Blooms: Understand
44
1. conversion Equals the conversion ratio divided into the par

premium value. 4
Equals the market price of a convertible bond minus
2. warrant the security's theoretical value. 1
Adjusts earnings per share for potential share
3. speculative issuances related to outstanding options, convertible
warrant premium securities and warrants. 7
4. conversion May be exchanged with the company, usually for
price shares of common stock. 8
Equals the market value of the common stock minus
the option price of the warrant all multiplied by the
5. financial number of shares each warrant entitles the holder to
sweetener purchase. 6
6. minimum The market price of the warrant minus the warrant's
warrant value intrinsic value. 3
7. diluted earnings May be used as a means to offer lower interest rates
per share on debt. 2
8. convertible The use of an equity option to facilitate sale of a
security debt security. 5
The right to sell an asset for a given time at a
9. put option specified price. 9

Blooms: Understand
45
95. Lucky Dog Pet Food has a $1000 convertible bond outstanding with a conversion price of $12.00 per
share. The bond pays an interest payment of $40 semiannually and matures in 20 years unless converted
into common stock earlier or called by the company. The common stock currently sells for $11.25 per
share. If the bond sold at its theoretical bond value it would be priced competitively to yield 10% with
bonds of the same risk class.
a) How many shares of stock are received on conversion?
b) What is the conversion value?
c) What is the pure bond value?
d) How much downside protection has the pure bond value provided to investors? (answer in dollars)

Blooms: Analytic
Blooms: Apply and Evaluate
46
96. The Whipple Corporation currently has common stock selling for $40 per share on the National Stock
Exchange. Warrants are also available entitling the warrant holder the option of purchasing 1 share of
common stock for every 3 warrants held. The exercise price is $32 per share. The warrants are currently
selling for $7 per warrant.
a) How much would you have to spend to buy one share of stock using the warrants? Does this make
sense?
b) What is the intrinsic value of the warrant?
c) What is the speculative premium on this warrant?
a)
Since you can buy the stock in the market for $40, you would not use 3 warrants to end up with one
share of stock. However, if you do not intend to buy the stock right away, you may be willing to pay a
$5 premium for each warrant and see if the stock goes up enough to make your purchase more attractive
in the future. One main consideration in the establishment of the premium is the length of time left
before the warrant must be exercised. The longer the time period, the higher the premium.
b)
c)

Blooms: Analytic
47
97. The XLarge Corporation has a convertible bond outstanding with a conversion price of $35 per share.
The $1000 par value bonds have a 6% annual coupon rate, paid semi-annually, and 20 years to maturity.
The firm's common stock is currently selling for $44 per share and the convertible bonds are selling for
$1,200.00.
a) Calculate the conversion ratio.
b) Calculate the conversion value.
c) If equivalent bonds are currently yielding 12% to maturity, what is the pure bond value of this bond?
d) How much downside protection does the pure bond value provide to an investor? Would this be an
appropriate investment for a risk-averse investor?
A risk averse investor would not buy this bond unless the underlying company and its common stock
had a stable price history accompanied by fairly certain growth. The downside loss potential is very
large if the stock price should decline dramatically.

Blooms: Analytic
48
98. Fred Jury is a portfolio manager who has $900,000 of a client's money to invest in highly speculative
instruments. Jury is contemplating the purchase of 40,000 shares of Shakee Corp. common stock, which
is currently selling on the American Stock Exchange at $30.00 per share. Alternatively, he could buy
warrants on Shakee Corp. common for $5.50. Each warrant gives the holder the right to buy one share
of Shakee Corp. common stock at $24.00 per share.
a) How many warrants could Mr. Jury buy with the $900,000?
b) If he had purchased the common stock directly, and its price had increased to $37.20 per share,
calculate his dollar and percentage return on the investment.
c) Assume that when the price of the stock goes to $37.20 per share, the warrant sells for its intrinsic
value. If Jury sells his warrants at this point, calculate his dollar and percentage return on the
investment.

Blooms: Analytic
Blooms: Apply
49
19 Summary
Category # of Qu
estions
AACSB: Ethics (ethical understanding and reasoning) 2
Block - Chapter 19 98
Blooms: Analytic 25
Blooms: Analyze 4
Blooms: Apply 12
Blooms: Apply and Evaluate 3
Blooms: Evaluate 6
Blooms: Remember 58
Blooms: Understand 15
Difficulty: Basic 37
Difficulty: Challenge 10
Difficulty: Intermediate 51
Learning Objective: 19-01 Convertible securities can be converted to common stock at the option of the owner. 23
Learning Objective: 19-02 Because these securities can be converted to common stock; they may move with the value of common stock. 33
Learning Objective: 19-03 Convertible bonds have a pure bond value based on interest paid. 20
Learning Objective: 19-04 Warrants are similar to convertibles in that they give the warrant holder the right to acquire common stock. 23
Learning Objective: 19- 10
05 Accountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement.
05 Accountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement. Acc
ountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement.
06 Derivative securities such as options and futures can be used by corporate financial managers for hedging activities.
06 Derivative securities such as options and futures can be used by corporate financial managers for hedging activities. Derivative securities
such as options and futures can be used by corporate financial managers for hedging activities.
50

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Chapter 19 Convertibles, Warrants, and Derivatives

8. Conversion premiums are influenced heavily by expectations of future stock performance.

24. A forced conversion will alter the corporate balance sheet.

48. A convertible security is almost always

A. a security that can be converted into any other type of security.

A. the bond will sell at its pure bond value.

51. The conversion ratio is the

A. price at which a convertible security is exchanged into common stock.

52. The conversion premium will be large

53. Which of the following is true?

A. large conversion premiums for the firm's convertible bonds.

57. The theoretical floor value for a convertible bond is its

58. The floor price of a convertible bond cannot fall below

A. the conversion ratio.

A. has downside as well upside limitations.

A. the conversion value equals the pure bond value.

61. The "floor" or pure bond value of a convertible bond is found by

63. A convertible bond is often utilized

A. as a sweetener when selling debt.

A. the stock price may never rise above conversion price.

66. Which of the following is not a characteristic of convertible bond issues?

A. The average size of the offering is small.

A. the premium would decrease.

68. One advantage to the corporation in selling a convertible bond is:

70. The principle device used by the corporation to force conversion

A. is setting the conversion price above the current market price.

71. When a company has a convertible bond in its capital structure,

A. it can reduce its debt-to-equity ratio by calling the bond.

72. A step-up in the conversion price refers to

A. all convertible securities.

77. Which of the following is true about warrants?

A. At high stock prices, the warrant premium is high.

79. Warrants are

A. long-term options to sell shares of the issuing firm's stock.

A. less than its intrinsic value.

85. A derivative is a financial instrument whose value is determined by

A. a regulatory body such as the SEC.

86. Options contracts contrast with futures because

A. options are not traded on organized exchanges.

A. the right and the obligation to buy an asset at a given price.

88. The owner of a put has

A. the right and the obligation to buy an asset at a given price.

89. Which contract is an option?

A. provides a low-cost financing alternative for large, high-quality companies

A. Lower times interest earned

93. Match the following with the items below:

1. convertible May be traded in to the company for a different

1. conversion Equals the conversion ratio divided into the par

8. Conversion premiums are influenced heavily by expectations of future stock performance.

Block - Chapter 19 #12

Block - Chapter 19 #13

Block - Chapter 19 #16

Block - Chapter 19 #17

Block - Chapter 19 #18

Block - Chapter 19 #19

24. A forced conversion will alter the corporate balance sheet.

Block - Chapter 19 #26

Block - Chapter 19 #27

Block - Chapter 19 #28

Block - Chapter 19 #33

Block - Chapter 19 #34

Block - Chapter 19 #35

Block - Chapter 19 #38

AACSB: Ethics (ethical understanding and reasoning)