FIN 540 Homework
Chapter 20 Advance Corporate Finance
Directions: Answer the following five questions on a
separate document. Explain how you reached the answer or show your work if a
mathematical calculation is needed, or both. Submit your assignment using the
assignment link in the course shell. Each question is worth five points apiece
for a total of 25 points for this homework assignment.
1. 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.
2. Which of the following statements about convertibles is
most CORRECT? a. One advantage of convertibles over warrants is that the issuer
receives additional cash money when convertibles are converted. b. Investors
are willing to accept a lower interest rate on a convertible than on otherwise
similar straight debt because convertibles are less risky than straight debt.
c. At the time it is issued, a convertible's conversion (or exercise) price is
generally set equal to or below the underlying stock's price. d. For
equilibrium to exist, the expected return on a convertible bond must normally
be between the expected return on the firm's otherwise similar straight debt
and the expected return on its common stock. e. The coupon interest rate on a
firm's convertibles is generally set higher than the market yield on its
otherwise similar straight debt.
3. Which of the following statements concerning warrants is
correct? a. Warrants are long-term put options that have value because holders
can sell the firm's common stock at the exercise price regardless of how low
the market price drops. b. Warrants are long-term call options that have value
because holders can buy the firm's common stock at the exercise price
regardless of how high the stock's price has risen. c. A firm's investors would
generally prefer to see it issue bonds with warrants than straight bonds
because the warrants dilute the value of new shareholders, and that value is
transferred to existing shareholders. d. A drawback to using warrants is that
if the firm is very successful, investors will be less likely to exercise the
warrants, and this will deprive the firm of receiving any new capital. e. Bonds
with warrants and convertible bonds both have option features that their
holders can exercise if the underlying stock's price increases. However, if the
option is exercised, the issuing company's debt declines if warrants were used
but remains the same if it used convertibles.
4. Which of the following statements is most CORRECT? a. One
important difference between warrants and convertibles is that convertibles
bring in additional funds when they are converted, but exercising warrants does
not bring in any additional funds. b. The coupon rate on convertible debt is
normally set below the coupon rate that would be set on otherwise similar
straight debt even though investing in convertibles is more risky than
investing in straight debt. c. The value of a warrant to buy a safe, stable
stock should exceed the value of a warrant to buy a risky, volatile stock,
other things held constant. d. Warrants can sometimes be detached and traded
separately from the debt with which they were issued, but this is unusual. e.
Warrants have an option feature but convertibles do not.
5. 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%
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