FINRA Series 7 — All Questions

Which describes a rights offering to existing shareholders?

• a.It is short-lived, with a subscription price below market✓
• b.It is long-lived, with a subscription price below the market price
• c.It is short-lived, with a subscription price above the market price
• d.It is long-lived, with an exercise price above market

Rights let current holders buy new shares ahead of the public at a discount, and they expire within weeks. Long-term life with an exercise price above market describes a typical warrant. A price above market gives holders no reason to subscribe, and rights do not last for years.Equity features

What is the longest time to expiration for LEAPS?

• a.Up to 36 months after the date they are listed
• b.Up to 39 months after listing✓
• c.Up to 60 months after the date they are listed
• d.Up to 24 months after the date they are listed

LEAPS are long-term equity options with expirations up to 39 months after listing. Shorter figures such as 24 or 36 months and the 60-month figure are not the contract maximum.OCC Options Disclosure Document

An investor holds five ABC 80 calls when ABC announces a 2-for-1 stock split. How will the position be adjusted?

• a.Five calls with a strike of 80, each covering 200 shares
• b.Five calls with a strike of 40, each covering 200 shares
• c.Ten calls with a strike of 80, each on 100 shares
• d.Ten calls with a strike of 40, each still covering 100 shares✓

For an even split such as 2-for-1, the OCC doubles the number of contracts and halves the strike, so the investor holds ten calls at 40, each still covering 100 shares. Keeping five contracts with 200 shares each, or keeping the 80 strike, would change the value of the position.OCC Rules

ABC pays its regular quarterly cash dividend while an investor holds listed ABC call options. What happens to the option terms?

• a.The strike is reduced by the dividend amount on the ex-date
• b.The expiration date moves back by one dividend period
• c.Nothing, since ordinary cash dividends do not adjust option terms✓
• d.The number of contracts rises to reflect the dividend that is paid out

Listed options are not adjusted for ordinary cash dividends, which is one reason call holders sometimes exercise early. Strike reductions, added contracts and shifted expirations are used for splits and certain other corporate actions, not regular dividends.OCC Rules

An issuer plans a Rule 506(b) private placement and wants to include a few investors who are not accredited. Which condition applies?

• a.Non-accredited purchasers are barred, and every buyer must be verified as an accredited investor
• b.Any number of non-accredited purchasers, provided the issuer advertises the offering publicly
• c.Up to 100 non-accredited purchasers, provided the offering is registered with a state regulator
• d.No more than 35 non-accredited purchasers, each financially sophisticated, and no general solicitation✓

Rule 506(b) allows up to 35 non-accredited purchasers, each of whom must be sophisticated (alone or with a purchaser representative), and bars general solicitation. Unlimited non-accredited buyers and public advertising are not allowed under this exemption, a ban on non-accredited buyers plus verification describes the 506(c) approach instead, and there is no 100-purchaser state-registration alternative.SEC Rule 506(b)

An issuer wants to advertise its private offering on social media and still rely on Regulation D. Which approach fits?

• a.Rule 506(b): advertise to accredited investors only, relying on each buyer's own written certification
• b.Rule 506(c): sell only to accredited investors, with reasonable steps to verify their status✓
• c.Rule 506(c): sell to any investor who signs a statement describing their financial sophistication
• d.Rule 506(b): advertise freely, then file Form D before the first sale for state review

General solicitation is permitted only under Rule 506(c), and then every purchaser must be accredited and the issuer must take reasonable steps to verify that status. Rule 506(b) prohibits general solicitation whether or not Form D is filed or buyers certify, and a sophistication statement does not replace accredited status and verification.SEC Rule 506(c)

A prospective investor owns a home worth $800,000 with a $300,000 mortgage, a brokerage account worth $700,000, a retirement account worth $400,000, and $50,000 of other debts. She earned $150,000 in each of the last two years. Under the net worth test, is she an accredited investor?

• a.No; the net worth test applies only to those whose income is also above $200,000 a year
• b.No; subtracting the $300,000 mortgage leaves her net worth excluding the home at $750,000
• c.No; her net worth excluding the home is $1,050,000, but the test requires $5,000,000
• d.Yes; her net worth excluding the home is $1,050,000, which is above the $1,000,000 threshold✓

The primary residence is excluded from net worth, and a mortgage on it up to the home's value is not counted as a liability. Her assets of $1,100,000 less $50,000 of other debts gives $1,050,000, above $1,000,000. The net worth test stands on its own, separate from the income test, and the $5,000,000 figure applies to certain entities, not individuals. Subtracting the home mortgage while excluding the home is the error in the first alternative.SEC Rule 501(a)

A non-affiliate has held restricted shares of a reporting company for 8 months. May she resell them under Rule 144?

• a.Yes, but only after filing Form 144 and waiting through a 90-day SEC review period
• b.Yes, but sales in any three-month period are limited to 1% of the outstanding shares
• c.No; a one-year holding period applies to every restricted security, whoever holds it
• d.Yes, if the issuer has current public information available; no volume limit applies to her✓

For a reporting issuer the holding period is six months. A non-affiliate who has held for more than six months but less than a year may sell if current public information about the issuer is available, and has no volume limit. Volume limits and Form 144 apply to affiliates, and no review waiting period exists.SEC Rule 144

An affiliate of a Nasdaq-listed issuer wants to sell restricted shares. The issuer has 2,000,000 shares outstanding and the average weekly trading volume over the last four weeks was 25,000 shares. What is the most she may sell in the three-month period?

• a.25,000 shares, the greater of 1% of shares outstanding or the average weekly volume✓
• b.45,000 shares, found by adding 1% of the outstanding shares to the average weekly volume
• c.20,000 shares, which is 1% of the shares outstanding, because that is the stricter measure
• d.100,000 shares, found by multiplying the average weekly volume by four weeks

For listed securities the affiliate limit is the greater of 1% of the shares outstanding (20,000) or the average weekly volume over the four calendar weeks before the sale notice (25,000). The greater figure, 25,000, governs. The measures are alternatives, not additive, and the volume figure is a weekly average, not a monthly total.SEC Rule 144

An affiliate plans to sell 4,000 restricted shares at $15 a share within a three-month period and has made no other sales. Must she file Form 144?

• a.No; the sale is under the 5,000-share threshold, so no Form 144 is required
• b.Yes; every sale by an affiliate requires Form 144, no matter how small the amount
• c.Yes; the sale proceeds exceed $50,000, even though the share count is under 5,000✓
• d.No; Form 144 applies only when an affiliate sells at least 10,000 shares in the period

An affiliate must file Form 144 when sales in any three-month period exceed 5,000 shares or $50,000 in aggregate sale price. 4,000 shares at $15 is $60,000, so the dollar test is met although the share test is not. Either test is enough, there is no 10,000-share threshold, and small sales do fall under the thresholds.SEC Rule 144

A company plans an offering under Regulation A, Tier 2. What is the most it may raise in a 12-month period?

• a.$75 million, counting sales by selling security holders in the same 12 months✓
• b.$10 million, the ceiling for every small issuer in the exemption
• c.$150 million, the ceiling once an issuer is an Exchange Act reporting company
• d.$20 million, the Tier 1 ceiling for the same 12-month period

Tier 2 of Regulation A permits offerings of up to $75 million in 12 months, and secondary sales count toward the cap. $20 million is the Tier 1 limit, and the other two figures do not match any Regulation A tier.SEC Regulation A

To keep its pass-through tax treatment, a real estate investment trust must generally:

• a.Hold at least 90% of its assets in residential mortgages rather than owned property
• b.Distribute at least 90% of its taxable income, excluding net capital gains, to shareholders✓
• c.Pass its tax losses to shareholders, who deduct them against ordinary income
• d.Reinvest at least 90% of its rental income in newly acquired properties each year

A REIT avoids entity-level tax on income it distributes, and it must distribute at least 90% of taxable income other than net capital gains. Reinvestment is not the test, losses stay inside the REIT and are not passed to shareholders, and a REIT may own property directly and may hold commercial or residential assets.IRC Section 856

A $400 million fund wants to qualify as diversified under the 75-5-10 test. Looking only at the 75% portion of its assets, what is the most it may hold in one issuer?

• a.$300 million, which is the entire 75% portion of assets
• b.$15 million, which is 5% of the 75% portion alone
• c.$20 million, which is 5% of total fund assets✓
• d.$40 million, which is 10% of total fund assets

In the 75-5-10 test, 75% of total assets must be in cash, government securities and other securities, with no more than 5% of total assets in any one issuer and no more than 10% of an issuer's voting stock. 5% of $400 million is $20 million. The 5% applies to total assets, not the 75% portion, and 10% is a voting-stock limit, not an asset limit.ICA Section 5(b)(1)

An investor sold 100 shares at $40 that cost $60 a share, then bought 100 shares of the same stock 20 days later at $42. What is the basis of the new shares?

• a.$6,000, the original cost carried over to the replacement shares
• b.$6,200, the price paid plus the $2,000 disallowed loss✓
• c.$2,200, the price less the $2,000 disallowed loss
• d.$4,200, the price paid, with the $2,000 loss deductible this year

A repurchase of substantially identical stock within 30 days before or after a loss sale is a wash sale. The $2,000 loss is disallowed and added to the new shares' basis: $4,200 + $2,000 = $6,200. The holding period also carries over. Deducting the loss now, carrying over the old cost, or subtracting the loss all misapply the rule.IRC Section 1091

A mother, a father and a grandparent each want to fund Coverdell ESAs for the same 10-year-old. What is the most that may be contributed for her in one year?

• a.$2,000 per account, so $6,000 if each person opens a separate account
• b.$2,000 per contributor, so $6,000 across the three of them combined
• c.$2,000 in total for the beneficiary, however many accounts or donors there are✓
• d.$2,000 from each of the two parents, plus $1,000 from the grandparent

The Coverdell limit is $2,000 per beneficiary per year in total, however many accounts exist and however many people contribute. Contributor-by-contributor, account-by-account and family-role limits do not exist. Contributors must also meet income limits and contributions stop at age 18 unless the beneficiary has special needs.IRC Section 530

A 529 plan account has been open for 16 years, and the beneficiary has unused funds. How much may be rolled over to the beneficiary's Roth IRA?

• a.A lifetime maximum of $15,000, and within each year's Roth contribution limit
• b.A lifetime maximum of $35,000, and within each year's Roth contribution limit✓
• c.No lifetime maximum; only the annual Roth IRA contribution limit applies
• d.A maximum of $35,000 each year, regardless of the annual Roth IRA contribution limit

A 529 account open at least 15 years may roll unused funds to the beneficiary's Roth IRA, up to a lifetime total of $35,000, with each year's rollover limited by the annual IRA contribution limit. It is not $35,000 a year, $15,000 is the open-years requirement mixed up with a dollar cap, and a lifetime cap does exist.IRC Section 529

A parent takes $10,000 from a 529 plan for a vacation. The withdrawal consists of $7,000 of contributions and $3,000 of earnings. What are the federal tax consequences?

• a.The $3,000 of earnings is taxed as income, and the 10% additional tax does not apply
• b.The $3,000 earnings are taxed as income, plus a 10% additional tax of $300✓
• c.The full $10,000 is taxed as income and carries a 10% additional tax of $1,000
• d.The $7,000 of contributions is taxed as income, and the $3,000 of earnings escape tax

On a nonqualified withdrawal only the earnings portion is taxable, plus a 10% additional tax on those earnings: $300 here. Contributions come back tax-free because they were made with after-tax dollars. Taxing the full amount, omitting the additional tax, and taxing contributions instead of earnings are each incorrect.IRC Section 529

An investor is short 3 XYZ calls with a $50 strike. XYZ declares a 2-for-1 stock split. After the standard OCC adjustment, the position is:

• a.Short 6 calls with a $50 strike, each covering 100 shares
• b.Short 3 calls with a $25 strike, each covering 200 shares
• c.Short 6 calls with a $25 strike, each covering 100 shares✓
• d.Short 3 calls with a $50 strike, each covering 100 shares

For a 2-for-1 split the OCC doubles the number of contracts and halves the strike, so 3 calls at $50 become 6 calls at $25, each still covering 100 shares. The aggregate exercise value stays at $15,000. Leaving the strike or contract count unchanged would create an artificial gain or loss.OCC By-Laws Art. VI

An investor sells one XYZ 40 put for 3 and is assigned when XYZ trades at 36. What is the investor's effective purchase price per share?

• a.$36, the market price on the day the put was assigned
• b.$37, the $40 strike less the $3 premium the investor kept✓
• c.$43, the $40 strike plus the $3 premium, treating the premium as a cost
• d.$40, the strike alone, since the premium was earned when the put was sold

The put writer must buy at the 40 strike, but the 3-point premium received offsets the cost, so the effective price is 40 - 3 = 37 ($37 per share). Adding the premium reverses its effect, ignoring the premium overstates the cost, and the market price at assignment is irrelevant to what the writer is obligated to pay.Option assignment

An investor buys a municipal bond with 10 full years to maturity at 98 in the secondary market. The $20 discount per $1,000 bond is a market discount. How is it treated at maturity?

• a.As $20 of ordinary income, as municipal market discount always is
• b.As $20 of ordinary income, because the de minimis limit is 0.25% of the $1,000 redemption price, or $2.50
• c.As a $20 capital gain, because it is under the $25 de minimis amount✓
• d.As tax-exempt interest, because the bond is a municipal bond and its interest is exempt

Market discount is treated as zero (de minimis) if it is less than 0.25% of the redemption price times the number of complete years to maturity: 0.0025 x $1,000 x 10 = $25. The $20 discount is below that, so the gain is capital. Municipal market discount is not always ordinary income, because the de minimis rule applies. Forgetting to multiply by the 10 years gives a $2.50 limit and the wrong ordinary-income result. Market discount is never tax-exempt interest, even on a municipal bond.IRC 1278(a)(2)(C)

A $1,000 par TIPS has a 2% coupon, and its adjusted principal is $1,030 on both interest dates in the year after inflation adjustments. What interest is paid for the year?

• a.$50.60, because interest is the coupon plus the inflation adjustment
• b.$20.00, because the coupon rate applies to the original par value
• c.$30.00, because interest equals the inflation adjustment to principal
• d.$20.60, because the coupon rate applies to adjusted principal✓

TIPS pay a fixed rate on the adjusted principal: 2% x $1,030 = $20.60 for the year. The inflation increase in principal is a separate item, taxed in the year it occurs, and is not part of the interest payment.Treasury TIPS

A closed-end fund has net assets of $240 million and 12 million shares outstanding. Its shares trade on an exchange at $18.00. The shares are trading at:

• a.A 10% discount, because the $2 gap is measured against $20 NAV✓
• b.An 11.1% discount, because the $2 gap is measured against the $18 price
• c.A 10% premium, because the shares trade $2 away from the $20 NAV
• d.A 90% discount, because the price is 90% of the $20 NAV

NAV per share is $240 million / 12 million = $20. Shares at $18 sit $2 below NAV, a 10% discount ($2 / $20). A premium would require a price above NAV. Dividing the gap by the $18 price uses the wrong base, and 90% is the price-to-NAV ratio, not the discount.Investment Company Act

A stock trades at $50 with rights attached. The subscription price is $40 and four rights are needed to buy one share. What is the theoretical value of one right while the stock still trades cum-rights?

• a.$5.00, found by (50 - 40) / 2
• b.$2.00, found by (50 - 40) / (4 + 1)✓
• c.$2.50, found by (50 - 40) / 4
• d.$10.00, the full gap between market and subscription price

Before the ex-rights date the value of one right is (market - subscription) / (rights per share + 1) = 10 / 5 = $2.00. Dividing by 4 is the ex-rights formula, the full gap ignores the number of rights needed, and dividing by 2 has no basis.Rights offerings

A registered broker-dealer owns and invests on a discretionary basis $30 million in securities of unaffiliated issuers. Under Rule 144A, is it a qualified institutional buyer?

• a.Yes, because a registered dealer needs only $10 million of such securities✓
• b.Yes, but only when the dealer buys for its own account rather than for other buyers
• c.No, because every qualified institutional buyer must own and invest $100 million
• d.No, because a dealer must also show an audited net worth of at least $25 million

Rule 144A sets the dealer threshold at $10 million of unaffiliated securities, so $30 million qualifies. The $100 million test applies to institutions such as insurance companies and investment companies. The audited net worth requirement belongs to the bank test, and a registered dealer may act for its own account or for the accounts of other qualified institutional buyers.SEC Rule 144A

A variable annuity is annuitized with an assumed interest rate of 4%. If the separate account earns 6% in the year, the annuity payments will:

• a.Increase only if the owner exchanges the contract for a fixed annuity
• b.Stay level, because annuitizing fixes the dollar amount of each payment
• c.Increase, because the 6% actual return exceeded the 4% assumed interest rate✓
• d.Decrease, because a return above the assumed rate lowers the unit value

Payments vary with the annuity unit value: when the separate account earns more than the AIR, payments rise; when it earns less, they fall. A fixed payment describes a fixed annuity, a return above the AIR cannot reduce the payment, and no exchange is needed for payments to rise.Variable annuities

A limited partner in a direct participation program has passive losses for the year. Those losses may generally be used to:

• a.Offset ordinary income without limit, since the partner bears the economic loss
• b.Offset wages and portfolio income up to $3,000 each year
• c.Offset passive income from other sources, with any excess carried forward✓
• d.Be carried back to earlier years to recover tax already paid on portfolio income

Passive losses offset only passive income. Unused amounts are suspended and carried forward until passive income arises or the interest is sold. The $3,000 allowance applies to capital losses, not passive losses, and the loss cannot offset wages or portfolio income without limit or be carried back against portfolio income.IRC Section 469

An investor buys a 10-year, 6% corporate bond at 92. Which statement correctly ranks the bond's yields?

• a.Nominal 6.00%, current yield 5.52%, and a yield to maturity above 6.00%
• b.Nominal 6.00%, current yield 6.52%, and a yield to maturity above 6.52%✓
• c.Nominal 6.00%, current yield 6.52%, and a yield to maturity below 6.00%
• d.Nominal 6.52%, current yield 6.00%, and a yield to maturity above 6.52%

The coupon is $60 on $1,000 par, and the price is $920, so the current yield is 60/920 = 6.52%. A discount bond also pays back par at maturity, so yield to maturity is higher than the current yield, which in turn is above the nominal 6.00%. A yield to maturity under 6.00% describes a premium bond. Calling 6.52% the nominal yield swaps the coupon rate and the current yield. A current yield of 5.52% subtracts the discount instead of dividing the coupon by the price.Bond yield measures (nominal, current, yield to maturity)

A 6% corporate bond bought at par later trades at 105. How have its nominal yield and its current yield changed?

• a.Nominal stays 6.00% and current yield rises to 6.30%
• b.Nominal falls to 5.71% and current yield stays 6.00%
• c.Nominal rises to 6.30% and current yield stays at 6.00%
• d.Nominal stays 6.00% and current yield falls to 5.71%✓

The nominal yield is the coupon divided by par, so it stays 60/1,000 = 6.00% no matter what the bond trades at. The current yield is the annual interest divided by the market price: 60/1,050 = 5.71%, lower because the investor pays more for the same $60. A rising nominal yield with an unchanged current yield swaps the two measures. A nominal yield that falls to 5.71% also swaps them, because the coupon rate is fixed by the indenture. A current yield of 6.30% multiplies the coupon by the price ratio instead of dividing by it.Bond yield measures (nominal yield versus current yield)

A customer buys a bond at 94 that is callable at par in three years and matures in 12 years. Which yield should the representative quote as the yield to worst?

• a.Nominal yield, because the coupon is the lowest return on the bond
• b.Yield to maturity, because a call at par would only add to the return✓
• c.Yield to call, because the issuer will call as soon as it can
• d.Current yield, because it ignores the call and maturity dates

Bought at 94, the investor gains 6 points if the bond is called at par in three years, which gives a higher return than waiting for maturity, so yield to maturity is the lower number and the worst case. Yield to call is the lowest figure only for bonds bought at a premium. Current yield and nominal yield ignore the repayment of principal, so neither is the yield-to-worst test.Yield to worst (callable bond bought at a discount)

A 10-year corporate bond yields 5.85% and the 10-year Treasury yields 4.60%. What is the yield spread, and what does a wider spread signal?

• a.125 basis points; wider spreads mean less credit risk
• b.1,250 basis points; wider spreads mean more risk
• c.12.5 basis points; wider spreads mean less risk
• d.125 basis points; wider spreads mean more risk✓

The spread is 5.85% - 4.60% = 1.25 percentage points, and one basis point is 0.01%, so the spread is 125 basis points. Investors demand a wider spread when they see more credit or liquidity risk in the corporate bond compared with the Treasury, so a widening spread signals more risk, not less. Stating 1,250 basis points treats a basis point as 0.001%. Stating 12.5 basis points treats it as 0.1%, and it also reads the widening the wrong way.Yield spread over Treasuries (basis points)

A bond's price changes by about $0.72 per $1,000 par for each basis point of yield change. If its yield rises 35 basis points, what is the approximate price change per bond?

• a.A gain of about $25.20
• b.A decline of about $2.52
• c.A decline of about $25.20✓
• d.A decline of about $20.16

35 basis points times $0.72 is $25.20 per bond, and the price falls because bond prices and yields move in opposite directions. A decline of $2.52 slips a decimal place. A gain of $25.20 gets the direction wrong. A decline of $20.16 uses 28 basis points rather than the 35 in the question.Price value of a basis point

A $1,000 par bond with a 5% coupon and 10 years to maturity is bought at 95. Using the approximate-yield formula (annual interest plus annual discount accretion, divided by the average of price and par), what is the approximate yield to maturity?

• a.5.00%
• b.5.13%
• c.5.26%
• d.5.64%✓

Annual interest is $50 and the $50 discount accretes at $5 a year, so the numerator is $55; the average of $950 and $1,000 is $975, giving 55/975 = 5.64%. A result of 5.26% is the current yield, 50/950, which leaves out the discount. A result of 5.00% is the coupon rate. A result of 5.13% accretes the discount over the year but still divides by par.Approximate yield to maturity

A bond with a 4.5% coupon has a current yield of 5.0%. At what price is it trading?

• a.$1,100
• b.$900✓
• c.$950
• d.$1,000

The annual interest is $45, and price = interest / current yield = 45 / 0.05 = $900. A price of $950 splits the difference between par and the true price. A price of $1,100 mistakenly reads a higher current yield as a premium. A price of $1,000 would give a current yield equal to the 4.5% coupon, not 5.0%.Bond yield measures (current yield and price)

A bond's quoted yield to maturity assumes which of the following?

• a.The bond is held to maturity and each coupon is reinvested at the coupon rate
• b.The bond is held to maturity and each coupon is reinvested at the yield to maturity✓
• c.The bond is sold in one year at the same yield and coupons are spent
• d.The bond is redeemed at its first call date and each coupon is spent

Yield to maturity is a return measure that assumes the investor holds to maturity and reinvests every interest payment at that same yield. An early redemption at the first call date is the assumption behind yield to call. A sale after one year at an unchanged yield is not part of the calculation. Reinvestment at the coupon rate would give a different return unless the bond happened to trade at par.Yield to maturity (reinvestment assumption)

A customer buys an 8% bond at 110 that matures in 10 years and is not callable. Which statement about the bond's yields is correct?

• a.Current yield is 8.00%, and the yield to maturity is higher than that
• b.Current yield is 7.27%, and the yield to maturity is lower than that✓
• c.Current yield is 7.27%, and the yield to maturity is higher than that
• d.Current yield is 8.80%, and the yield to maturity is lower than that

The current yield is $80 divided by $1,100, which is 7.27%. The $100 premium is lost when the bond is redeemed at par, so the yield to maturity falls below the current yield and the nominal yield of 8%. A higher yield to maturity describes a discount bond. A current yield of 8.80% multiplies the coupon by the price ratio. A current yield of 8.00% is just the coupon rate.Bond yield measures (premium bond)

A railroad finances new locomotives by issuing debt that is secured by the locomotives themselves, with a trustee holding title until the last certificate is paid. Which security is this?

• a.Collateral trust bond
• b.First mortgage bond
• c.Subordinated debenture
• d.Equipment trust certificate✓

An equipment trust certificate is secured by specific rolling stock, aircraft or similar equipment, and the trustee keeps title until the debt is retired. A collateral trust bond is secured by securities the issuer deposits, not by physical equipment. A first mortgage bond is secured by real property such as track and buildings. A subordinated debenture is unsecured and ranks behind other debt.Corporate bond types (equipment trust certificates)

A holding company deposits shares of its operating subsidiaries with a trustee as security for a new bond issue. This bond is best described as a:

• a.parent-guaranteed bond
• b.first mortgage bond
• c.equipment trust certificate
• d.collateral trust bond✓

Bonds secured by securities that the issuer owns and pledges with a trustee are collateral trust bonds. A first mortgage bond is secured by a lien on real property. An equipment trust certificate is secured by specific equipment, not by securities. A parent-guaranteed bond relies on another company's promise to pay, which says nothing about pledged securities.Corporate bond types (collateral trust bonds)

Which list ranks claims on a liquidating corporation's assets from highest priority to lowest?

• a.Secured bondholders, subordinated debenture holders, debenture holders, preferred stockholders, common stockholders
• b.Secured bondholders, debenture holders, subordinated debenture holders, preferred stockholders, common stockholders✓
• c.Debenture holders, secured bondholders, subordinated debenture holders, preferred stockholders, common stockholders
• d.Secured bondholders, debenture holders, preferred stockholders, subordinated debenture holders, common stockholders

Secured creditors look first to their collateral, general unsecured creditors such as debenture holders come next, and subordinated debt is contractually junior to them. Equity ranks after all debt, with preferred ahead of common. Putting subordinated debentures ahead of ordinary debentures reverses their contractual ranking. Placing preferred stock ahead of subordinated debt treats equity as senior to debt. Ranking unsecured debentures above secured bonds ignores the claim on collateral.11 U.S.C. Section 726 and Section 507 (priority of claims in liquidation)

After secured creditors and all other senior claims are paid, a liquidating company has $5 million left. Its debentures are owed $4 million, its subordinated debentures $3 million, and there is preferred and common stock outstanding. What happens to the subordinated debenture holders?

• a.They receive $1 million, about one-third of their claim, and equity holders receive nothing✓
• b.They receive $3 million in full, and the debenture holders absorb the shortfall
• c.They receive nothing, because only senior debt and preferred stock are paid before common
• d.They receive $1.5 million, sharing the $5 million evenly with the debenture holders

Debenture holders are paid first, taking $4 million in full and leaving $1 million, which goes to the subordinated holders against their $3 million claim, about one-third. Nothing remains for preferred or common stockholders. Subordinated holders cannot jump ahead of senior debentures. Creditors of different rank do not share pro rata. Subordinated debt still ranks above all equity, including preferred stock.11 U.S.C. Section 726 (distribution in liquidation); subordination agreements

A company issues income bonds. In a weak year, its earnings fall short of the interest due and it pays no interest. Which statement is correct?

• a.The missed payment is generally not a default, because interest is owed only to the extent earned✓
• b.The missed interest is added to the principal, because the bonds are payment-in-kind
• c.The trustee may accelerate the principal, because any missed coupon is a default
• d.The company must redeem the bonds at par, because earnings tests act as a put feature

Under an income bond indenture, interest is payable only if the issuer has earned it, so a skipped payment in a low-earnings year is ordinarily not an event of default. Acceleration by the trustee follows a default on an ordinary bond, not on an income bond. Payment-in-kind bonds are a different structure that pays in additional securities. An earnings shortfall gives holders no right to put the bonds back to the issuer.Corporate bond types (income bonds)

Compared with a fixed-rate note of the same maturity and credit quality, how does a floating-rate note's price usually react when market interest rates rise?

• a.It falls by the same amount, because duration depends only on maturity
• b.It stays closer to par, because the coupon resets to follow the benchmark rate✓
• c.It rises, because the higher benchmark makes the note more valuable than par
• d.It falls further, because the coupon cannot rise until the maturity date

A floating-rate note resets its coupon to a benchmark plus a spread, so its price tends to stay near par when rates move. A fixed coupon cannot adjust, which is why a fixed-rate note falls further. The claim that the coupon cannot rise before maturity describes the fixed-rate note. A price above par would require the coupon to exceed what the market now demands. Resets shorten the effective duration, so price sensitivity is not the same as for a fixed-rate note.Corporate bond types (floating-rate notes)

A corporate indenture contains a sinking fund provision. What is the primary effect for the bondholders?

• a.The issuer retires part of the issue before maturity, which reduces the amount due in one lump sum at the end✓
• b.The bonds convert into common stock on a schedule, which reduces the interest paid in each period
• c.The holder may require the issuer to buy the bond back at par on set dates before maturity
• d.A third-party insurer guarantees the principal, which raises the rating to the insurer's level

A sinking fund requires the issuer to set aside money or retire bonds on a schedule, so less principal is left as a balloon at maturity and default risk at the end is lower. A right to sell the bond back to the issuer is a put feature. Scheduled conversion into stock is not a sinking fund; conversion is a separate option. A third-party guarantee of principal is bond insurance or credit enhancement.Corporate bond indenture features (sinking fund)

A 10-year corporate bond has a make-whole call provision. How is the price the issuer must pay on an early call generally determined?

• a.Par value alone, payable only when the call-protection period has fully ended
• b.Par plus a fixed premium that falls by half a point for each year the bond is outstanding
• c.Par plus the next coupon, plus a premium fixed at issuance and unchanged through maturity
• d.Present value of remaining coupons and principal, discounted at a Treasury yield plus a spread✓

A make-whole call prices the bond at the present value of the payments the holder gives up, discounted at a benchmark Treasury yield plus a small spread, which makes calling expensive when rates have fallen. A premium that declines by a set schedule is a conventional call schedule. Par plus a fixed premium is a negotiated penalty, not a make-whole formula. A call at par after protection ends is an ordinary call price.Corporate bond call features (make-whole call)

Which of the following debt offerings is exempt from the qualification requirements of the Trust Indenture Act of 1939?

• a.A registered $300 million convertible debenture of a manufacturer
• b.A registered $75 million first mortgage bond of an electric utility
• c.A registered $200 million subordinated debenture of a bank
• d.A general obligation bond issued by a county or city government✓

Securities issued or guaranteed by a state or a political subdivision are exempt from the Trust Indenture Act, so a city's general obligation bond needs no qualified indenture. Large registered corporate offerings of notes, bonds or debentures must be issued under a qualified indenture with an independent trustee, whether they are subordinated, secured or convertible, and the small-offering exemption covers only $10 million or less.Trust Indenture Act of 1939, Section 304 (exempted securities)

A $1,000 convertible debenture is convertible at $40 per share. The common stock trades at $44 and the bond trades at $1,150. How does the bond's price compare with its conversion value?

• a.The bond is at parity with a $1,150 conversion value
• b.The bond is $150 above its $1,000 conversion value
• c.The bond is $50 above its $1,100 conversion value✓
• d.The bond is $50 below its $1,200 conversion value

The conversion ratio is $1,000 / $40 = 25 shares, so conversion would deliver 25 x $44 = $1,100 of stock. The bond sells $50 above that parity value, a conversion premium of about 4.5%. Treating the $1,000 par as the conversion value ignores the stock price altogether. A $1,200 conversion value would require the stock to be at $48. A $1,150 conversion value would require a stock price of $46, and at $44 the bond would be at parity only if it traded at $1,100.Convertible bonds: conversion ratio, parity and conversion premium

An investor owns a $1,000 convertible bond with a conversion price of $50. The issuer declares a 2-for-1 forward split of its common stock, and the indenture's anti-dilution clause adjusts the conversion terms. What are the adjusted terms?

• a.Conversion price $50 and conversion ratio of 40 shares
• b.Conversion price $100 and conversion ratio 10 shares per bond
• c.Conversion price $25 and conversion ratio 20 shares per bond
• d.Conversion price $25 and conversion ratio 40 shares per bond✓

Before the split the ratio is $1,000 / $50 = 20 shares. A 2-for-1 split doubles the shares, so the ratio rises to 40 and the price halves to $25, which keeps ratio x price at the $1,000 par. The price of $100 with 10 shares is the adjustment for a 1-for-2 reverse split. Keeping the price at $50 while moving to 40 shares would be worth $2,000 of par value. Moving the price to $25 while leaving 20 shares would reduce the claim to $500.Convertible bond indenture: anti-dilution adjustment for stock splits

A company has 10 million shares outstanding and net income of $20 million. It also has $50 million of 4% convertible bonds that convert into 1 million shares, and its tax rate is 30%. Under the if-converted method, what is fully diluted EPS?

• a.$2.14, adding the interest to the old shares
• b.$1.95, adding back the after-tax interest✓
• c.$2.00, adding back interest before tax
• d.$1.82, adding the shares with no interest back

Interest on the bonds is $50 million x 4% = $2 million, or $1.4 million after a 30% tax rate. If the bonds were converted, that interest would not be paid, so net income becomes $21.4 million on 11 million shares, which is $1.945 or $1.95. Adding the shares without the interest add-back gives $20 / 11 = $1.82. Adding back the full pre-tax $2 million gives $22 / 11 = $2.00, which overstates income because interest is tax-deductible. Adding the interest back but leaving out the new shares gives $21.4 / 10 = $2.14.FASB ASC Topic 260 (Earnings Per Share), if-converted method

A convertible bond is callable at 103. The issuer announces a call while the shares into which the bond converts are worth $1,200 per bond. What should a rational holder do?

• a.Keep the bond, because a call cannot be enforced on a convertible
• b.Tender the bond at $1,030, because the issuer set that price
• c.Convert, because the shares are worth $1,200 versus the $1,030✓
• d.Wait for the call date, since conversion ends once a call is announced

Conversion is worth $1,200 per bond and redemption pays only $1,030, so converting captures $170 more. A call on a bond that is in the money is how issuers force conversion. Redemption at $1,030 gives up that value. A convertible cannot be kept after a valid call, since the issuer may redeem it. Conversion rights normally continue until shortly before the redemption date, so a call notice does not end them, but a holder who waits risks missing the deadline and gains nothing by delaying.Convertible bond indenture: issuer call and conversion value

A corporate bond rated BBB- by S&P is downgraded by one notch. How is the bond classified afterward?

• a.Investment grade, since BB+ is still the lowest investment-grade rating
• b.Below investment grade, at BB+ (Ba1 at Moody's), a fallen angel✓
• c.Below investment grade, at BB+ (Ba1 at Moody's), a rising star
• d.Below investment grade, at B+ (B1 at Moody's), a fallen angel

BBB- (Baa3 at Moody's) is the lowest investment-grade rating, so one notch lower is BB+ (Ba1), which is speculative or high-yield. A bond that falls from investment grade to high-yield is a fallen angel. BB+ is the top speculative notch, not the bottom of investment grade. One notch below BBB- does not reach B+, which is four notches lower. A rising star is a high-yield bond upgraded into investment grade, the opposite direction.S&P / Moody's rating scales (BBB-/Baa3 investment-grade cutoff)

A manufacturer reports EBIT of $90 million, depreciation of $15 million, interest expense of $15 million, taxes of $30 million and net income of $45 million. What is its times-interest-earned ratio?

• a.3.0 times, from net income over interest
• b.4.0 times, from taxed EBIT over interest
• c.6.0 times, from EBIT over interest✓
• d.7.0 times, from EBITDA over interest

Times interest earned is EBIT divided by interest expense, or $90 million / $15 million = 6.0. Interest is paid before taxes, so the pre-tax operating figure is used. Net income of $45 million is already after interest and taxes and gives 3.0. Reducing EBIT by taxes to $60 million gives 4.0. EBITDA of $105 million gives 7.0, but depreciation is a non-cash expense that the standard ratio does not add back.Credit analysis: times interest earned (EBIT / interest)