Series 7

Lesson 1 Equity Securities

What is a Security?
Dilution of Equity for a shareholder: An additional primary issue of shares would dilute a
present shareholder's ownership, unless she personally purchases a portion of the new
shares (as in a rights offering). In a secondary offering, ownership of existing outstanding
shares is simply changing hands. With a stock dividend or stock split, percent equity does
not change.

The OTC Market: An informal network of market makers that offers to trade securities
NOT listed on an exchange is called OTC Market. This best describes the over-the-
counter market which is an interdealer market linked by computer terminals to Financial
Industry Regulatory Authority (FINRA) member firms across the country.

Stock
Stock issued minus stock reacquired equals the amount of stock outstanding. Shares
repurchased are called treasury stock.

Common stock is a junior security. It is considered less safe than bonds because it has the
lowest claim to assets in the event of the issuing firm's liquidation, and is paid dividends
after bonds are paid interest. Common stockholders are always the last to receive
payment in the event of a corporate liquidation and, therefore, have the most risk.
However, common stockholders have the greatest potential reward of ownership if the
corporation is successful.

A company may, from time to time, go into the market and buy some of its own
outstanding stock, which is then placed in the treasury and called treasury stock. Treasury
stock has no voting rights and does not receive dividends. Treasury stock is not included
when calculating shareholders' equity, or net worth.

Treasury stock is a company's stock that has been issued, sold through an offering, and
then bought back by the company. When a company repurchases its own stock, that stock
has no voting rights or dividend rights and is held in the issuer's treasury.

Common and preferred stocks represent ownership in a company. Convertible debentures

may be converted to equity securities, but until they are, they are considered debt.

CS Stockholder rights:
Ownership of common stock allows shareholders the right to vote on the important
affairs in the life of the company, not routine operational decisions. No promise is offered
with regard to the stockholder's initial investment, which might be lost, or dividends,
which might not be declared.

Preemptive rights allow stockholders to maintain their proportionate ownership when the
corporation wants to issue more stock. For example, if a stockholder owns 5% of the
outstanding stock and the corporation wants to issue more stock, the stockholder has the
right to purchase 5% of the new shares.

Common stockholders of publicly traded companies have a residual claim to assets of a

corporation at dissolution and are entitled to receive an annual report containing audited
financial statements. Stockholders never get to vote on dividends.

Shareholder approval is not required for the payment of dividends, but is normally
required for actions that increase (or potentially increase) the number of shares
outstanding, such as stock splits and the issuance of convertible bonds. A corporation's
acceptance of a tender offer requires shareholder approval.

Stockholders are entitled to vote on the issuance of additional securities that would dilute
shareholders' equity (the shareholder's proportionate interest). Conversion of the bonds
would cause more shares to be outstanding, thus reducing the proportionate interest of
current stockholders. Decisions that are made by the board of directors and do not require
a stockholder vote include the repurchase of stock for its treasury, declaration of a stock
dividend, and declaration of a cash dividend.

Common stockholders are entitled to dividend distributions in proportion to their

ownership and to residual rights to corporate assets on dissolution. They do not vote on
the payment of dividends, and they have only limited liability.

The residual right of common shareholders refers to their position in the event of
bankruptcy. CS residual rights claim company assets in bankruptcy after wages, taxes,
creditors and preferred shareholders have been paid.

Common shareholders must vote to approve the issuance of additional preferred stock
because additional preferred shares dilutes the common shares' residual assets under a
liquidation. Common shareholders do not vote to declare dividends. Board members
select the chairman of the board. Shareholders do not get involved in the daily
operational activity of the corporation.

A stockholder owns 200 shares of common stock in a corporation that features statutory
voting. If an election is being held in which 6 candidates are running for 3 seats on the
board, the stockholder could cast the votes in which of the following ways? 200 votes for
each of 3 directors. (EXPLAIN) A stockholder has 1 vote per seat for each share of
stock he owns. Thus, in this case, the stockholder has a total of 600 votes. Under the
statutory voting method, he must allocate an equal number to each seat, or 200 for each
of 3 seats.

Cumulative voting allows shareholders to aggregate their votes and cast them as they
please. For example, they could cast all of their votes for a single candidate. Cumulative
voting makes it easier for a minority group of shareholders to gain representation on the
board.
Minority stockholders are more likely to be able to elect representatives to the board of
directors through cumulative voting. Small stockholders may cast all of their votes on 1
position rather than spread them out and thus dilute them over 2 or 3 positions.

A change in earnings would affect the price of CS. Common stock is most sensitive to
earnings changes because, as owners, common shareholders have a claim on the earnings
of the firm.

Stock Valuation:
The price-to-earnings ratio equals the market price divided by earnings per share. The PE
ratio is 14, and earnings per share is $3. Therefore, the market price is 14 × $3 = $42.

Stock Split:
-When a stock splits, the number of shares each stockholder has either increases or
decreases (in the case of a reverse split). The customer experiences no effective change in
position because the proportionate interest in the company remains the same.

When a reverse split takes place, the number of outstanding shares is reduced. Since the
split has no effect on earnings of the company, dividing those earnings by fewer shares
will cause an increase to the earnings per share.

If ABC Corp. declares a 5-4 stock split, an investor who owns 300 shares would receive
how many additional shares? 75 shares

In a 3-for-2 stock split, an investor will have 50% more shares at two-thirds the price.

-After a 2 for 1 split, the transfer agent will send the investor another certificate for 100
shares. The investor is not required to return the existing stock certificate. Since each
shareholder will receive additional stock, the proportional equity will remain the same.

-After a 2-1 stock split, the number of outstanding shares doubles and the par value per
share decreases by half. Retained earnings are not affected.

-In a 2-for-1 stock split, the number of outstanding shares is doubled and the price is
reduced by half. The total market value (market cap) of the issuer's stock remains the
same.

-After a reverse split, there will be fewer shares outstanding. As a result, market price and
earnings per share will increase. Overall, the market capitalization of the company will
not change.

-ABC Inc. has 1 million shares of common stock outstanding ($10 par value), paid-in
surplus of $10 million, and retained earnings of $10 million. If ABC stock is trading at
$20 per share, what would be the effect of a 2-1 stock split? - A stock split results in more
outstanding shares at a lower par value per share. The total value of stock outstanding is
unchanged. Retained earnings are not affected by a stock split.

-As a result of a stock split, an investor will have more shares at less value per share, but
overall value of the investment will remain the same. For example: an investor owns 100
shares at $50 per share worth $5,000. After a 5-4 split, the investor will have 125 shares
(100 × 5/4); the total ownership interest of $5,000 is divided by the new number of shares
to determine the per share price of $40. The decrease of 50 to 40 is a 20% reduction.
Generally, the percent decrease in price will always be less than the percent increase in
the number of shares. The percent increase in shares in a 5-4 split is 25%.

Just as the total portfolio value of an individual does not change when splits and stock
dividends occur, the index will experience no real change, because the stock value used
in the index is weighted by the number of shares outstanding.

Preferred Stock
Which of the following features of preferred stock allows the holder to reduce the risk of
inflation? Convertible. Fixed dollar investments such as bonds and preferred stock are
subject to inflation risk, which is the risk that the fixed interest or dividend payments will
be worth less over time in terms of purchasing power. The ability to convert to common
stock, which tends to keep pace with inflation, offsets this risk.

Preferred stock conversion: Par value divided by conversion price equals the number of
shares into which the security is convertible. If this security is convertible into 5 shares,
we need to know what number goes into $100 5 times. That number is $20. The current
market value of the preferred stock is unnecessary information.
Calculation space:

A customer purchases an ABC 6-½% convertible preferred stock at $80. The conversion
price is $20. If the common stock is trading 2 points below parity, the price of ABC
common is: The conversion ratio is computed by dividing par value by the conversion
price ($100 par / $20 = 5). Parity price of the common stock is computed by dividing the
market price of the convertible by the conversion ratio ($80 / 5 = $16). $16 − 2 = $14
Calculation Space:

Current and unpaid past dividends on cumulative preferred stock must be paid before
common stockholders can receive a dividend. Bond interest is always paid before
dividends. Dividends in arrears on cumulative preferred have the highest priority of
dividends to be paid.

Before paying any dividends, the corporation must pay wages, taxes, and both interest
and principal on debts that are due. Once the debt obligations have been satisfied, it may
pay arrearages on cumulative preferred stock, then current fixed dividends on preferred
stock, and finally common dividends.

The rate on an adjustable preferred stock may be indexed to the TBILL rate. The
dividend on an adjustable rate preferred stock is tied to a particular interest rate, and the
Treasury bill rate is a common benchmark.

By issuing a callable preferred stock, a corporation can call in a high dividend payment
issue and replace it with a lower one when interest rates decline. Callable preferred
allows the company to take advantage of reduced interest rates by calling in high-rate
issues and replacing them with lower ones. The marketplace requires that the company
pay a higher dividend yield compared to one that is not callable. This compensates the
investor for taking the risk of a future call. Q&A: Callable preferred stock is
advantageous to the issuer because it allows the company to replace a high, fixed-rate
issue with a lower issue after the call date.

Preferred shareholders do not generally have voting rights. Voting rights are
characteristic of common stock, not preferred. Preferred stock is unlike debt securities in
that it has no set maturity date. It is true that the dividend on a preferred stock is fixed,
except in the case of an adjustable preferred where the dividend can be tied to a market
interest rate and readjusted. The holder of a preferred has to sell the shares in the open
market to close out his position.

Noncumulative preferred stock, the company must pay only this year's full stated
dividend of $10 per share (10% on 100 par value) before paying dividends to the
common shares. Not previous years as with cumulative preferred stock.

Preferred stock is interest rate sensitive. As rates fall, prices of preferred stocks tend to
rise, and vice versa. Similar to a fixed income bond – interested rate risk. Preferred stock
has the closest characteristics to bonds and would be most affected by a change in interest
rates. Convertible preferred stock would also be affected by price changes in the
underlying common stock.

A customer owns cumulative preferred stock (par value of $100) that pays an 8%
dividend. The dividend has not been paid this year or for the 2 previous years. How much
must the company pay the customer per share before it may pay dividends to the common
stockholders? 100 x .08 = 8$ x 3 years = $24

Straight preferred is the benchmark rate. As the name suggests, there are no conversion or
participating features. Compared to straight preferred, both convertible and participating
preferred tend to carry lower dividend rates, as the investor has been given something
extra-the right to convert into common shares at a fixed price or the right to earn more
than the stated rate if the issuer has a good year and the board of directors elects to make
an additional dividend payment. Callable preferred allows the issuer to call the securities
away from the investor. From an investor's point of view, this is not an incentive.
Therefore, callable preferred tends to pay higher rates.

When the stock is called, dividend payments are no longer made. With callable preferred
stock, to compensate for that possibility, the issuer pays a higher dividend than with
straight preferred. Cumulative and convertible preferred have positive characteristics that
would justify a lower fixed dividend than straight.

Dividends:
All dividends, both common and preferred, must be declared by the board of directors.
Preferred shares usually have a fixed dividend rate and usually have no (or very limited)
voting powers. Both types of stock are equity, not debt, securities.

A common stock's dividend payment and amount are determined by the company's board
of directors.

A company may pay a dividend in stock of another company, cash, its own stock, or its
own product. Preemptive rights are used in subsequent primary offerings, and bonds trade
separately.

ABC's stock has paid a regular dividend every quarter for the last several years. If the
price of the stock has remained the same over the past year, but the dividend amount per
share has increased, it may be concluded that ABC's: The current yield would have
increased because current yield is the income (dividend) divided by price. A higher
dividend divided by the same price results in a higher yield. Stocks do not have a yield to
maturity.

GHI currently has earnings of $4 and pays a $.50 quarterly dividend. If GHI's market
price is $40, the current yield is: 5% (The quarterly dividend is $.50, so the annual
dividend is $2; $2 /· $40 market price = 5% current yield.)
Calc. Space:
A company with 20 million shares outstanding paid $36 million in dividends. If the
current market value of the company's shares is $36, the current yield is: 5% (The current
yield formula is annual dividends per share divided by current market price. The
dividends per share are $36 million /· 20 million shares = $1.80 per share. Current yield
is $1.80 / $36.00 = 5%.)
Calc. space:

GHI stock is at $10 par value and is selling in the market for $60 per share. If the current
quarterly dividend is $1, the current yield is: 6.7% (Current yield is determined by
dividing the annual dividend of $4 ($1 per quarter × 4 = $4) by the current stock price of
$60 ($4 / $60 = 6.7%). Calc. space:

A company has paid a dividend every quarter for the past 20 years. If the stock's price has
fallen dramatically over the past quarter, but the dividend has remained the same, it may
be concluded that: current dividend yield has increased. Current dividend yield is income
dividend divided by price. If the price of a stock decreases and the dividend remains the
same, dividend yield will increase.

A customer purchases stock for $40 per share, holds it for 10 months, and then sells it for
$50 per share. If the customer's tax bracket is 30%, what is the after-tax rate of return?
17.5% - The customer's return on the stock is the $10-per-share short-term capital gain
($50 − $40). The after-tax rate of return is found by computing the after-tax earnings ($10
[100% - 30%] or $10 [.70] = $7) and dividing this amount by the amount originally
invested ($7 / $40 = .175 or 17.5%). Short-term gains are taxed at the same rate as
ordinary income. Calc. Space:

Return on Investment (ROI)

Your customer owns 100 shares of DWQ trading at $50 per share. He hears that DWQ
has declared a 25% stock dividend and wants to know how that will affect his holdings
after the stock dividend is paid. You should advise the customer that based on the current
price he will own: The number of shares increased by 25%, or 25 shares. Total market
value remains the same. To calculate the new market price, divide $5,000 (total market
value) by 125 to get the after-dividend price of $40 per share. Calc Space:
A stock dividend results in an increased number of outstanding shares, each with a lower
value per share. The total value of stock outstanding is unchanged. There is no new
capital generated from a stock dividend. Current assets are unchanged because there is no
increase or decrease to the company's cash as a result of the stock dividend.

Which of the following statements regarding the effects of a stock dividend is TRUE?
The market value of the stock is decreased.

Transferability of Ownership

Which of the following statements regarding the Committee on Uniform Securities

Identification Procedures (CU.S.IP) number is CORRECT? It facilitates tracking and
identification of a security. The CU.S.IP assigns a unique number to each class of
common and preferred stock and to each issue of corporate and municipal bond; this
number is used to identify and track a particular security. The stock certificate itself, not
the CU.S.IP number, is evidence of ownership in the issuing company. The presence of a
CU.S.IP number does not make a security negotiable.

The registrar's function is to ensure that the number of shares outstanding does not
exceed the number accounted for on the corporation's books.

The transfer agent records the names of stockholders on the corporation's books, cancels
old shares, and transfers shares into a new owner's name.

The registrar accounts for the number of shares and audits the transfer agent.

The registrar is responsible for keeping careful account of the number of shares a
company is authorized to issue and ensuring that the number outstanding does not exceed
this number.

For reporting purposes, an order to sell 25 shares of an OTC equity security priced at
$230 per share is: 25 round lots. For OTC equity securities trading at or above $175 per
share, 1 share is considered to be a round lot unit of trading. Therefore all last sale
information will be disseminated for any transaction of one share or more.

When disseminating information about transactions of OTC equity securities, 1 share

equals 1 round lot for stocks trading at or above: $175 per share. In instances where OTC
stocks are trading at or above $175 per share, 1 share equals 1 round lot. In all other
cases, similar to listed equity securities, 100 shares equals 1 round lot for OTC equity
securities.

Ex-Dividend!!!!

The regular way ex-dividend date for cash dividends is the: The regular way ex-dividend
date is 2 business days before the record date.
The board of directors is responsible for setting all of the following EXCEPT:

DERP (Ex-Dividend is always 2 bus. Days before Record date on Cash Dividends)

Anyone who owns the stock on the record date will receive the dividend. In a regular way
trade, the seller will still be owner of record on record date, as the trade will settle after
the record date. In a cash settlement transaction, the buyer will be owner of record on
record date.

ABC Corporation has declared a record date of Thursday, May 17, for its next quarterly
cash dividend. When is the last day the investor may purchase the stock regular way and
receive the dividend? Monday May 14th. In order to receive a cash dividend, an investor
must be owner of record as of the close of business on record date. Because regular way
settlement is 3 business days, the customer must purchase the stock no later than
Monday, May 14.

If a stock's ex-dividend date is Tuesday, January 13, when is the record date? The record
date is two business days after the ex-dividend date (Thursday, January 15).

The ex-dividend date is the:

I. date on and after which the buyer is entitled to the dividend.

II. date on and after which the seller is entitled to the dividend.
III. second business day before the record date.
IV. second business day after the record date.

The record date is set by the corporation, at which time a list of stockholders who will
receive a dividend is compiled.

While looking at a stock listing in the financial section of your local newspaper, you
notice that the dividend is indicated by the notation ".15q." If you owned 1,000 shares,
you could anticipate annual dividends of: 600. The notation .15q indicates a quarterly
dividend of $.15. Therefore, the annual dividend is $.60 per share. 1,000 shares × .60 =
the annual dividend of $600.

The last day that stocks can be bought for cash and still receive the dividend is: record
date. A cash trade settles the same day. Stocks bought for cash on the record date will be
entitled to the dividend under an exception to the 2-business day rule for regular way
transactions.

The ex-date for NYSE-listed issues is set by: NYSE.

Rights and Warrants

The following chart shows the capital transactions of ABC Corporation.

Date Event Amount

10-19-96 Initial Offerings 6 million shares
4-1-2000 Treasury Purchase 500,000 shares

ABC wants to raise additional capital by selling 2 million shares through a rights offering
and engages an underwriter on a standby basis. By the expiration date, ABC was only
able to sell 1 million shares to existing shareholders. After expiration, how many shares
does ABC have outstanding?  

 A) 7.5 million.
 B) 6.5 million.
 C) 7 million.
 D) 8 million.

Answer: A - Before the rights offering, the company had 5.5 million shares outstanding
(6 million issued minus 500,000 Treasury shares). In connection with the offering, ABC
engages a standby underwriter that commits to purchase any unsold shares. Therefore,
regardless of the number of shares initially subscribed to, all 2 million shares will be
sold.

Usually, a warrant is issued along with a debt instrument, an enhancement that allows
the issuer to offer a slightly lower rate of interest. If a corporation attaches warrants to a
new issue of debt securities, which of the following would be a resulting benefit to the
corporation? Reduction of the debt securities’ IR.

Warrants represent long-term options to buy stock at a fixed price, and, like options,
cannot pay dividends.

ABC, Inc. will issue new stock through a rights offering. Terms of the offering are 10
rights plus $10 to purchase one new share of stock, with any fractional shares to be
considered whole shares. ABC is currently trading at $13. If your customer owns 85
shares of ABC and wishes to subscribe to the new offering, how many shares can she
purchase at the subscription price and how much money will be required? 9Shares / $90.

Your customer is entitled to 90 rights with her current holding of 85 shares (fractional
shares are rounded up). Because each share requires 10 rights and $10, the customer can
buy 9 shares and must pay $90. CALC SPACE:
A new bond issue will include warrants to: Increase the attractiveness of the issue to the
public. By including warrants with debt issues, issuers increase the marketability of
bonds. The warrants offer a long-term opportunity to buy the underlying stock at a fixed
price. In addition to increasing the marketability of the issue, the issuer can offer the
bonds with a lower coupon rate and, as a result, reduce fixed costs.

All of the following statements describe stock rights EXCEPT:

 A) they are short-term instruments that become worthless after the expiration
date.
 B) they are issued by a corporation.
 C) they are traded in the secondary market.
 D) they are most commonly offered with debentures to make the offering more
attractive.

 Answer: D
 A corporation issues rights to existing shareholders to allow them to purchase
enough stock, within a short period and at less than current market price, to
maintain their proportionate interest in the company. Rights need not be exercised
but may be traded in the secondary market. Warrants, not rights, are often issued
with debentures to sweeten the offering.

All of the following statements describe warrants EXCEPT:

 A) issued by a corporation.
 B) traded in the secondary market.
 C) short-term instruments that become worthless after the expiration date.
 D) most commonly offered in connection with debentures to sweeten the offering

 Answer: C
 Warrants are commonly used to make debenture offerings more attractive and
have long lives (generally 2 to 10 years). Warrants need not be exercised, but may
be traded in the secondary market.

ABC Corporation, whose common stock is trading at $32, has issued $40 million of 8-
1/8% debentures due 10-1-14. Each bond issued has a warrant attached enabling the
holder to buy 4 shares of ABC common at $40 per share. If all of the warrants are
exercised, ABC Corporation will receive:

 A) $6.4 million.
 B) $10 million.
 C) $12.8 million.
 D) $20 million. CALC SPACE
 Answer: A

There are a total of 40,000 warrants outstanding ($40 million of debentures / $1,000 par
value per bond). Each warrant entitles the holder to buy 4 shares of common stock.
Therefore, if all warrants are exercised, holders will be purchasing 160,000 shares (4 ×
40,000) at $40 per share. 160,000 × $40 = $6.4 million.

Holders of warrants have the right to buy stock from the issuer at a stated price for a
specific time period. Warrants are attractive to speculators because the subscription price
is higher than the current market price at issuance; therefore, the warrants' purchase price
is low, as they are out-of-the-money. Dividends are only paid to stockholders.

Smith and Co., Inc. has 1 million shares of common stock outstanding and plans to sell
200,000 new shares via a rights offering. Joe Wilson, a common stockholder, owns 200
shares of the company. How many rights will he receive in the mail, and how many rights
will it take to purchase one of the new shares?

 A) 200 rights, 5 per share.

 B) 100 rights, 5 per share.
 C) 100 rights, 20 per share.
 D) 200 rights, 20 per share. CALC SPACE

Answer: A

Stockholders receive one right per share owned. Hence, Joe receives 200 rights. The
purpose is to maintain shareholders' proportionate interest in the company. Since the
number of shares outstanding will increase by 20%, Joe needs to purchase 40 new shares
(200 / 40 = 5 rights per share).

ABC, a publicly held Corporation, decides to issue shares in an additional public

offering. If the APO is for an additional 1 million shares and 60% of the shares are
subscribed to in the preemptive rights offering, how many shares will the standby
underwriter for this offering have available to sell to the public?

 A) 100,000.
 B) 110,000.
 C) 600,000.
  D) 400,000. CALC SPACE

 Answer: D

If 60% of the additional shares are subscribed to by existing shareholders, then 40% of
the additional shares will be available to be sold to the public through a standby (firm
commitment) underwriting (1,000,000 × 40% = 400,000).

Current shareholders may maintain their percentage of ownership of a company by

buying a proportional number of shares of any future issue of common stock. Purchasing
shares prior to public orders is also known as a "preemptive right" and is often available
only if made explicit in a company's corporate charter. Subscription rights: the right of
current shareholders to maintain their fractional ownership of a company by buying a
proportional number of shares of any future issue of common stock.

A warrant is a security that allows the holder to purchase shares of the underlying issue
at a fixed price (above the current market price when issued) for an extended period
(typically 2 years or longer). Call options are similar, except they are short-term
securities (9 months at issue).

Gargantuan Computers, Inc. (GCI) is proposing an additional public offering of common

stock. It conducts a rights offering to its current shareholders at $55 per share, plus 5
rights. If the current market price of GCI is $70, what is the value of one right before the
stock trades ex-rights?

 A) 2.5.
 B) 3.
 C) 5.
 D) 15. CALC SPACE

Answer: A

The stock is trading cum rights, which means that 5 rights plus 1 are used to value the
rights. The difference between the market price and the subscription price is $15 ($15 / 6
= $2.50).

New Offering: 800,000 units at $6 per unit. Each unit has 2 shares of common stock and
1 warrant. Each warrant is to purchase ½ share of common stock. Based on the
information above, how many shares of stock will be sold, and how many warrants will
be sold?
  A) 800,000 shares and 400,000 warrants.
 B) 800,000 shares and 200,000 warrants.
 C) 1.6 million shares and 800,000 warrants.
 D) 1.6 million shares and 400,000 warrants. CALC SPACE:

Answer: C

Warrants may be distributed to stockholders in an underwriting as part of a unit. The

warrant is a form of bonus to entice investors to purchase the unit. As each unit contains
2 shares, 1.6 million shares are being distributed. As each unit also includes 1 warrant,
800,000 warrants are being distributed.

A tombstone for a new bond issue announces that 5-year warrants to purchase shares of
the company's common stock at $75 are attached to the bonds. The current market value
of the company's stock is $45. For what reason were the warrants attached to the bonds
by the issuer?

 A) To decrease the dilution of the current shareholders.

 B) To make the bonds convertible into the issuer's common stock.
 C) To improve the marketability of the bond issue.
 D) To increase the dilution of the current shareholders.

Answer: C

Warrants are often issued as a bonus (or sweetener) to entice investors to purchase new
bond issues. Dilution may occur at the time the warrants are exercised (if ever), but this
would not be a reason for their issuance. A warrant has nothing to do with the bond's
convertibility into the underlying common stock.

All of the following are characteristics of a rights offering EXCEPT:

 A) the subscription price is below the CMV.

 B) it is issued to current stockholders.
 C) the rights are marketable.

 D) the subscription period is up to 2 years. Rights offerings are usually very short-
lived (30 to 45 days).
A member of the investment banking department of ABC securities is explaining some of
the advantages and disadvantages of rights and warrants to the board of directors of XYZ
Corporation. Which of the following statements could he make?

I. The exercise prices of stock rights are usually below CMV of the underlying
security at time of issue.
II. The exercise prices of warrants are usually above CMV of the underlying security
at time of issue.
III. Both rights and warrants may trade in the secondary market and may have prices
that include a speculative (time) value.
IV. Warrants are often issued attached to a bond issue to reduce the interest costs to
the issuer.

 A) I only.
 B) I and II.
 C) I, II and III.
 D) I, II, III and IV. Answer: D

All are true statements. The exercise prices of stock rights are usually below CMV of the
underlying security at time of issue. The exercise prices of warrants are usually above
CMV of the underlying security at time of issue. Both rights and warrants may trade in
the secondary market and may have prices that include a speculative (time) value.
Warrants are often issued attached to a bond issue to reduce the interest costs to the
issuer.

Warrants usually have lifetimes of 2-10 years; rights expire in 30-45 days. A corporation
may attach warrants to other securities, such as bonds, to make the bonds more
marketable. Warrants have no intrinsic value when issued and may expire without ever
having intrinsic value. Before expiration, they may be, and often are, traded in the
secondary market.

Rights are not redeemable by the issuer. They may be sold in the secondary market or be
given to someone else to exercise. If exercised, rights are exchanged for an appropriate
number of shares of the underlying common stock.

ADR

Dividends may be paid to holders of:

 A) rights.
 B) warrants.
 C) treasury stock.
 D) American depositary receipts.
Answer: D

American depositary receipt (ADR) owners have most of the rights common stockholders
normally hold. One of these includes the right to receive dividends when declared. Rights
and warrants allow holders to purchase stock from a corporation and treasury stock is
stock that has been issued by the corporation and then bought back. Neither rights,
warrants or treasury stock holders have the right to receive dividends.

ADRs are receipts issued by U.S. banks that represent ownership of a foreign security
and are traded in U.S. securities markets.
ADR owners have all the following rights EXCEPT:

 A) the right to sell in the secondary market.

 B) the right to receive dividends in U.S. dollars.
 C) the right to receive the underlying foreign security.
 D) the right to sell the ADR in the foreign market.

Answer: D

The purpose of the ADR is to facilitate trading in U.S. markets. The ADR can only be
traded here. If the owner exercises the right to obtain the actual foreign security, it may
be sold overseas.

All of the following are advantages of investing in American Depositary Receipts

(ADRs) EXCEPT:

 A) ADRs fall under the oversight of the SEC.

 B) dividends are received in U.S. currency.
 C) transactions are done in U.S. currency.
 D) currency risk is virtually eliminated.

Answer: D

ADRs carry currency risk because distributions on ADRs must be converted from foreign
currency to U.S. dollars on the date of distribution. In addition, the trading price of the
ADR is affected by foreign currency fluctuation.

Which of the following statements regarding ADRs are TRUE?

I. They are issued by large domestic commercial banks.

II. They are issued by foreign banks.
III. They facilitate U.S. trading in foreign securities.
IV. They facilitate a foreign investor who wants to trade U.S. securities.

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

Answer: B

ADRs are issued by large domestic commercial banks to facilitate U.S. investors who
want to trade in foreign securities.
An ADR is a negotiable security that represents an ownership interest in a non-U.S.
company. Because they trade in the U.S. marketplace, ADRs allow investors convenient
access to foreign securities.

Which of the following statements regarding ADRs are TRUE?

I. Dividends are payable in the underlying foreign currency.

II. Dividends are payable in U.S. dollars.
III. Holders have voting rights.
IV. Holders do not have voting rights.

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

Answer: A

The holder of an ADR does not hold the shares of the underlying security but instead
holds a receipt for those shares and therefore does not have voting rights. ADRs are U.S.
securities traded in U.S. markets in U.S. dollars, with dividends payable in U.S. dollars as
well.

Which of the following taxes does NOT impact the holder of an ADR?

 A) Federal income tax.

 B) State income tax.
 C) Foreign income tax.
 D) Excise tax.

Answer: D

Dividends on ADRs are subject to both federal and state income tax. In addition, the
country of origin will frequently levy a tax which may be used as a credit on the
investor's federal income tax return.

The American Depositary Receipt (ADR) is issued by a foreign branch of a domestic

bank. Everything is in English and in U.S. dollars.

An American Depository Share (ADR) represents an ownership interest in a foreign

domiciled company. The shares trade on the New York Stock Exchange or in the OTC.
The risk of lack of liquidity is absorbed by the presence of trading on U.S. exchanges or
in the OTC market. The shares are subject to market risk, political risk, and foreign
currency risk.
ADRs permit an American investor to purchase, not stock, but a certificate of deposit for
stock in a foreign company. The advantage is that the transactions are done in dollars, but
the ADR itself does not carry a vote or stock rights, and subjects the owner to currency
risk.

Investors should always be aware of taxes applicable to investments they own. Which of
the following taxes might be associated with income derived from ADRs but not income
from other investments?

 A) Federal income tax.

 B) State income tax.
 C) Excise tax.
 D) Foreign income tax.

Answer: D

In most countries, a withholding tax on dividends is taken at the source. To the holder of
an ADR, this would be a foreign income tax. The foreign income tax paid may be taken
as a credit against U.S. income taxes owed.

Any tax taken on dividends received from ADRs is taken in the country of origin. This is
a foreign withholding tax for U.S. investors. The foreign withholding tax may later be
taken as a credit against any U.S. income taxes owed by the U.S. investor.

REIT

Which of the following are characteristics of a REIT?

I. It is traded on an exchange or over the counter.

II. It is professionally managed.
III. It passes through both gains and losses to investors.
IV. It is a type of limited partnership.

 A) III and IV.

 B) I and II.
 C) I and IV.
 D) II and III.

Click for Answer and Explanation

Answer: B
A REIT shares some features with a limited partnership, but it is a different type of
business entity. REITs are traded on exchanges and OTC and are professionally
managed. Both REITs and limited partnerships provide pass-through of gains to
investors, but REITs do not provide pass-through of losses.

REITs are not redeemed by the issuer. REITS are publicly traded units that represent
either an interest in pooled capital for real estate financing or an interest in real property
and that pass through income and capital gains distributions to investors. Investors who
wish to liquidate their interests must sell them in the secondary market.

A REIT is a professionally managed company that invests in a diversified portfolio of

real estate holdings. REITs are traded on exchanges and OTC, which provides liquidity.
The IRS does not permit tax deferrals on REIT investments.

If a client who seeks diversification through real estate is concerned about illiquidity
associated with investing in real estate, which of the following investments is most
suitable? Real estate investment trusts (REITs) are best suited to the client because
they are market-traded securities that provide an investor with a liquid market in which to
invest in real estate.

All of the following are true of REITs EXCEPT:

 A) they must to qualify under Subchapter M, distribute at least 90% of their net
investment income.
 B) they must be organized as trusts.
 C) they must pass along losses to shareholders.
 D) they must invest at least 75% of their assets in real estate-related activities.
Answer: C

REITs engage in real estate activities and can qualify for favorable tax treatment if they
pass through at least 90% of their net investment income to their shareholders. While
they can pass through income, they cannot pass through any losses; they are not DPPs.

REITs can distribute their income to shareholders but not their losses. Under subchapter
M of the Internal Revenue Code, they must distribute at least 90% of their income to
shareholders in the form of cash dividends.

Cash dividends from REITs are taxed as ordinary income. They do not qualify for a
maximum rate of 15%, which applies to qualifying dividends from common stock.

Which of the following terms does NOT apply to REITs?

 A) Redeemable.
 B) Managed.
 C) Secondary market.
 D) Subchapter M.
Answer: A

A redeemable security is one for which there is no secondary market. The issuer stands
ready to redeem if a customer wishes to sell. However, REITs trade in the secondary
market and are not redeemable. The real estate portfolio is actively managed and REITs
are subject to Subchapter M of the Internal Revenue Code.

Which of the following is an equity security?

 A) Collateralized mortgage obligation.

 B) Government National Mortgage Association pass-through certificate.
 C) Real estate investment trust share.
 D) Mortgage-secured bond.

Answer: C

A REIT share is an equity security that represents undivided ownership in a portfolio of

real estate investments. The other choices are debt securities.

A trust set up to invest in real estate, mortgages, construction, and development loans that
must distribute at least 90% of its net income to avoid paying taxes on the income
distributed is called:

 A) a unit investment trust.

 B) an open-end investment company.
 C) a trust indenture.
 D) a real estate investment trust.

Answer: D

A real estate investment trust, in order to avoid tax on its income, must distribute 90% of
its net investment income to investors.

The similarities between a real estate investment trust (REIT) and a real estate limited
partnership include:

 A) flow-through of losses.
 B) no tax to the entity if at least 90% of net income is distributed.
 C) all of these.
 D) centralization of management.
Answer: D

Though a real estate investment trust is not established as a limited partnership, both legal
entities are established to provide centralization of management. The limited partnership
allows for the flow-through of gains, losses, deductions, etc. The REIT may be
established as a qualified REIT if 90% of the net investment income flows through to the
investor, but never allows losses, expenses, and deductions to flow through.