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Hybrid and Derivative Securities
Accontancy (BSA)
Tarlac State University
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Chapter 16
Hybrid and Derivative Securities
Learning Goals
Differentiate between hybrid and derivative securities and their roles in the corporation.
Review the types of leases, leasing arrangements, the lease-versus-purchase decision, the effects of leasing on future financing, and the advantages and disadvantages of leasing.
Describe the types of convertible securities, their general features and financing with convertibles.
Demonstrate the procedures for determining the straight bond value, conversion (or stock) value, and market value of a convertible bond.
Explain the key characteristics of stock-purchase warrants, the implied price of an attached warrant, and the values of warrants.
Define options and discuss the basics of calls and puts, options markets, options trading, the role of call and put options in fund raising, and using hedging foreign currency exposures with options.
True/False
- Derivatives are used by corporations as a useful tool for managing certain aspects of the firm’s risk.
Answer: TRUE Level of Difficulty: 1 Learning Goal: 1 Topic: Derivative Basics
Options is a security that is neither debt nor equity but derives its value from an underlying asset that is often another security. Answer: TRUE Level of Difficulty: 1 Learning Goal: 1 Topic: Options
Preferred stock is considered a hybrid security because it blends the characteristics of both bond and equity. Answer: TRUE Level of Difficulty: 2 Learning Goal: 1 Topic: Preferred Stock
678 Gitman • Principles of Finance, Eleventh Edition 4. A direct lease is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset, making periodic payments for its use. Answer: FALSE Level of Difficulty: 1 Learning Goal: 2 Topic: Direct Leases
- Leasing is considered a source of financing provided by the lessee to the lessor.
Answer: FALSE Level of Difficulty: 1 Learning Goal: 2 Topic: Leasing Basics
If a lessee leases (under a financial lease) an asset that subsequently becomes obsolete, it can require the lessor to replace it with an equally productive asset in real term over the remaining term of the lease. Answer: FALSE Level of Difficulty: 1 Learning Goal: 2 Topic: Financial Leases
The lease arrangement has many more restrictive covenants than those normally included as part of a long-term loan. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Leasing Basics
An operating lease is noncancelable and obligates the lessee to make payments for the use of an asset over a predefined period of time. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Operating Leases
A financial lease is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for five or fewer years, for an asset’s services. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Financial Leases
A leveraged lease is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Leveraged Leases
680 Gitman • Principles of Finance, Eleventh Edition 18. Since operating leases result in the receipt of services from an asset without increasing the assets or liabilities on the firm’s balance sheet, leasing may result in misleading financial ratios. Answer: TRUE Level of Difficulty: 3 Learning Goal: 2 Topic: Operating Leases
Conversion ratio is the ratio at which a convertible security can be exchanged for a nonconvertible security. Answer: FALSE Level of Difficulty: 1 Learning Goal: 3 Topic: Capitalized Leases
The conversion feature permits the firm’s capital structure to be changed without increasing the total financing. Answer: TRUE Level of Difficulty: 1 Learning Goal: 3 Topic: Capitalized Feature
Diluted earnings per share (EPS) are found by adjusting basic EPS for the impact of converting all convertibles and exercising all warrants and options that would have diluting effects on the firm’s earnings. Answer: TRUE Level of Difficulty: 1 Learning Goal: 3 Topic: Diluted EPS
Convertibles can normally be sold with lower interest rates than non-convertibles.
Answer: TRUE Level of Difficulty: 1 Learning Goal: 3 Topic: Convertible Securities
By using convertible bonds, the issuing firm can temporarily raise debt, which is typically less expensive than common stock, to finance projects. Answer: TRUE Level of Difficulty: 1 Learning Goal: 3 Topic: Convertible Bonds
The presence of contingent securities such as warrants and stock options affects the reporting of the firm’s earnings per share. Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Contingent Securities
Chapter 16 Hybrid and Derivative Securities 681 25. Because a security is first sold with a conversion price above the current market price of the firm’s stock, conversion is initially not attractive. Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Conversion Price
The conversion ratio can be obtained by dividing the par value of the convertible by the conversion price. Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Conversion Ratio
Convertibles can be used as a form of deferred common stock financing.
Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Convertible Securities
Since the conversion feature provides the purchaser of a convertible bond with the possibility of becoming a stockholder, convertible bonds are generally a less expensive form of financing than similar-risk nonconvertible or straight bonds. Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Convertible Bonds
Conversion price is the value of a convertible security as measured by the market price of the common stock into which it can be converted. Answer: FALSE Level of Difficulty: 2 Learning Goal: 3 Topic: Conversion Price
Since the purchaser of a convertible security is given an opportunity to become a common stockholder and to share in the firm’s future success, convertibles can normally be sold with higher interest rates than nonconvertibles. Answer: FALSE Level of Difficulty: 2 Learning Goal: 3 Topic: Convertibles versus Nonconvertibles
In case of an overhanging issue, if the firm were to call the issue, the bondholders would accept the call price rather than convert the bonds. Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Overhanging Convertible Issue
Chapter 16 Hybrid and Derivative Securities 683 39. The conversion value of a bond is the minimum price at which a convertible bond would be traded.
Answer: FALSE Level of Difficulty: 3 Learning Goal: 4 Topic: Conversion Value
The market premium may be defined as the amount by which the conversion value exceeds its straight value. Answer: FALSE Level of Difficulty: 3 Learning Goal: 4 Topic: Conversion Value
A stock-purchase warrant gives the holder the right to purchase a certain number of shares of common stock at a specified price over a certain period of time. Answer: TRUE Level of Difficulty: 1 Learning Goal: 5 Topic: Stock Purchase Warrants
The exercise price or option price of a warrant is normally set below the market price of the firm’s stock at the time of issuance. Answer: FALSE Level of Difficulty: 1 Learning Goal: 5 Topic: Features of Warrants
The stock-purchase warrant permits the firm to raise additional funds at some point in the future by selling common stock and thereby shifting the firm’s capital structure to a less highly levered position. Answer: TRUE Level of Difficulty: 2 Learning Goal: 5 Topic: Stock Purchase Warrants
The market value of a warrant is generally below the theoretical value of the warrant.
Answer: FALSE Level of Difficulty: 2 Learning Goal: 5 Topic: Value of Warrants
- Contrary to convertibles, warrants provide for the injection of additional equity capital into the firm at some future date. Answer: FALSE Level of Difficulty: 2 Learning Goal: 5 Topic: Features of Warrants
684 Gitman • Principles of Finance, Eleventh Edition 46. While, unlike convertible securities, warrants cannot be called, their limited life stimulates holders to exercise them when the exercise price is below the market price of the firm’s stock. Answer: TRUE Level of Difficulty: 2 Learning Goal: 5 Topic: Features of Warrants
In comparison to convertibles, the exercise of a warrant shifts the firm’s capital structure to a less highly levered position. Answer: TRUE Level of Difficulty: 2 Learning Goal: 5 Topic: Features of Warrants
Both warrants and rights result in new capital equity. However, warrants are issued at an exercise price below the prevailing market price of the stock; rights are generally issued at a subscription price above the prevailing market price. Answer: FALSE Level of Difficulty: 2 Learning Goal: 5 Topic: Warrants versus Rights
The warrant premium depends largely on investor expectations and the ability of investors to get more leverage from the warrants than from the underlying stock. Answer: TRUE Level of Difficulty: 2 Learning Goal: 5 Topic: Features of Warrants
The striking price is the price at which the holder of a call option can buy a specified amount of stock at any time prior to the option’s expiration date. Answer: TRUE Level of Difficulty: 1 Learning Goal: 6 Topic: Features of Warrants
The option buyer who expects a stock price to decline will purchase a put option.
Answer: TRUE Level of Difficulty: 1 Learning Goal: 6 Topic: Option Basics
- Options are a special type of security that provides the holder with the right to purchase or sell specified assets at a stated price on or before a set expiration date. Answer: TRUE Level of Difficulty: 1 Learning Goal: 6 Topic: Option Basics
686 Gitman • Principles of Finance, Eleventh Edition 60. A financial lease is often also referred to as a capital lease. Answer: TRUE Level of Difficulty: 1 Learning Goal: 1 Topic: Financial Leases
Maintenance clauses are provisions normally included in an operating lease that require the lessor to maintain the assets and to make insurance and tax payments. Answer: TRUE Level of Difficulty: 2 Learning Goal: 2 Topic: Lease Maintenance Clauses
Renewal options normally require the lessor to maintain the assets and to make insurance and tax payments. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Lease Renewal Options
Renewal options are provisions normally included in an operating lease that grant the lessee the right to re-lease assets at the expiration of the lease. Answer: TRUE Level of Difficulty: 2 Learning Goal: 2 Topic: Lease Renewal Options
Purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity. Answer: TRUE Level of Difficulty: 2 Learning Goal: 2 Topic: Lease Purchase Options
Renewal options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Lease Renewal Options
One advantage of leasing is that in many cases, the return to the lessor is quite high so the firm in need of the asset might be better off borrowing to purchase it. Answer: FALSE Level of Difficulty: 2 Learning Goal: 2 Topic: Advantage of Leasing
Chapter 16 Hybrid and Derivative Securities 687 67. One disadvantage of leasing is that in many cases, the return to the lessor is quite high so the firm in need of the asset might be better off borrowing to purchase it. Answer: TRUE Level of Difficulty: 2 Learning Goal: 2 Topic: Disadvantage of Leasing
Contingent securities such as convertibles, warrants, and stock options affect the reporting of a firm’s earnings per share (EPS). Answer: TRUE Level of Difficulty: 2 Learning Goal: 3 Topic: Contingent Securities
Contingent securities such as common stocks and bonds affect the reporting of a firm’s earnings per share (EPS). Answer: FALSE Level of Difficulty: 2 Learning Goal: 3 Topic: Contingent Securities
In general, the market value of a convertible security is likely to be greater than its straight value or conversion value. Answer: TRUE Level of Difficulty: 2 Learning Goal: 4 Topic: Valuing Convertible Securities
In general, the market value of a convertible security is likely to be less than its straight value or conversion value. Answer: FALSE Level of Difficulty: 2 Learning Goal: 4 Topic: Valuing Convertible Securities
One of the major reasons for attaching a stock purchase warrant is that investors do not require the issuing firm to pay an interest rate as high as on a security that does not have an attached warrant. Answer: TRUE Level of Difficulty: 3 Learning Goal: 5 Topic: Stock Purchase Warrants
One of the major reasons for not attaching a warrant is that investors require the issuing firm to pay a higher interest rate if a warrant is attached than if it is not. Answer: FALSE Level of Difficulty: 3 Learning Goal: 5 Topic: Stock Purchase Warrants
Chapter 16 Hybrid and Derivative Securities 689
Multiple Choice Questions
- The following securities are all popular hybrid securities EXCEPT
(a) financial leases. (b) convertible securities. (c) options. (d) stock purchase warrants. Answer: C Level of Difficulty: 1 Learning Goal: 1 Topic: Hybrid Securities
A form of debt or equity financing that possesses characteristics of both debt and equity financing is called (a) hybrid security. (b) convertible security. (c) derivative security. (d) None of the above. Answer: A Level of Difficulty: 1 Learning Goal: 1 Topic: Hybrid Securities
_________ lease is a contractual arrangement whereby the lessee agrees to make periodic payments to the lessor for five or fewer years for an asset’s services. This type of lease may also be canceled at the option of the lessee. (a) A financial (b) An operating (c) A capital (d) A direct Answer: B Level of Difficulty: 1 Learning Goal: 2 Topic: Operating Leases
Assets leased under _________ leases generally have a usable life longer than the term of the lease.
(a) financial (b) operating (c) capital (d) direct Answer: B Level of Difficulty: 1 Learning Goal: 2 Topic: Operating Leases
690 Gitman • Principles of Finance, Eleventh Edition 5. A capital or capitalized lease is otherwise known as (a) an operating lease. (b) a financial lease. (c) a direct lease. (d) a leveraged lease. Answer: B Level of Difficulty: 1 Learning Goal: 2 Topic: Financial Leases
A _________ is normally initiated by a firm that needs funds for operations. An asset previously owned by a lessee is sold to the lessor. (a) direct lease (b) leveraged lease (c) sale-leaseback (d) capital lease Answer: C Level of Difficulty: 1 Learning Goal: 2 Topic: Sale-Leaseback
In a _________, the lessor acts as an equity participant supplying part of the necessary capital while a lender supplies the remaining balance. (a) direct lease (b) leveraged lease (c) sale-leaseback (d) capital lease Answer: B Level of Difficulty: 1 Learning Goal: 2 Topic: Leveraged Leases
_________ leases are noncancelable and are generally used for leasing land, buildings, and large pieces of fixed equipment. (a) Financial (b) Operating (c) Serial (d) Direct Answer: A Level of Difficulty: 2 Learning Goal: 2 Topic: Financial Leases
692 Gitman • Principles of Finance, Eleventh Edition 13. Disadvantages of leasing from the lessee’s perspective include all of the following EXCEPT (a) the return to the lessor is quite high. (b) prohibition on leasehold improvements. (c) under a financial lease, an asset may subsequently become obsolete. (d) the maximum claim of the lessor in the event of bankruptcy is three years of lease payments. Answer: D Level of Difficulty: 3 Learning Goal: 2 Topic: Disadvantages of Leasing
- All of the following must be considered when making a lease-versus-purchase decision EXCEPT
(a) the after-tax cash flows for each year under the lease alternative. (b) the after-tax cash flows for each year under the purchase alternative. (c) the present value of all cash flows. (d) the depreciation expense under the lease. Answer: D Level of Difficulty: 3 Learning Goal: 2 Topic: Lease versus Purchase Decision
FASB Standard No. 13 establishes requirements for the explicit disclosure of certain types of lease obligations on the firm’s balance sheet. To qualify as a capital lease, any of the following elements may be present EXCEPT (a) the lease transfers ownership of the property to the lessee by the end of the lease. (b) the lease contains an option to purchase the property at a “bargain” price. (c) the lease term is less than 75 percent of the economic life of the property. (d) at the beginning of the lease, the present value of the lease payment is equal to 90 percent or more of the fair market value of the leased property less any investment tax credit received by the lessor. Answer: C Level of Difficulty: 4 Learning Goal: 2 Topic: Accounting for Leases
FASB Standard No. 13 requires explicit disclosure of _________ obligation on the firm’s balance sheet. For this type of lease, the present value for all of its payments is shown as an asset and the total lease payment obligation is included as a liability on the firm’s balance sheet. (a) an operating lease (b) a leveraged lease (c) a sale-leaseback (d) a capital lease Answer: D Level of Difficulty: 4 Learning Goal: 2 Topic: Accounting for Leases
Chapter 16 Hybrid and Derivative Securities 693 17. A security that is neither debt nor equity but derives its value from an underlying asset that is often another security is called (a) hybrid security. (b) convertible security. (c) derivative security. (d) None of the above. Answer: C Level of Difficulty: 1 Learning Goal: 3 Topic: Derivative Securities
A _________ is an option included as part of a bond or preferred stock that permits the holder to convert the security into a specified number of shares of common stock. (a) put option (b) stock-purchase warrant (c) conversion feature (d) repurchase agreement Answer: C Level of Difficulty: 1 Learning Goal: 3 Topic: Conversion Feature
Convertible bonds normally have _________ to permit the issuer to retire or encourage conversion.
(a) a put option (b) a call feature (c) a stock purchase warrant (d) a striking price Answer: B Level of Difficulty: 1 Learning Goal: 3 Topic: Convertible Bonds
- Convertible preferred stock is normally converted into
(a) secured bonds. (b) debentures. (c) shares of common stock. (d) warrants. Answer: C Level of Difficulty: 1 Learning Goal: 3 Topic: Convertible Preferred Stocks
Chapter 16 Hybrid and Derivative Securities 695 25. The call price of the security generally _________ the security’s par value.
(a) is less than (b) is equal to (c) is greater than (d) has no relation to Answer: C Level of Difficulty: 2 Learning Goal: 3 Topic: Call Price
- The purchaser of a convertible issue sacrifices a portion of his or her interest return
(a) to raise temporarily cheap funds. (b) due to the reduced risk of default. (c) when the call feature is exercised. (d) for the potential opportunity to become a common shareholder in the future. Answer: D Level of Difficulty: 2 Learning Goal: 3 Topic: Convertible Securities
An advantage of a convertible security is that it provides for deferred common stock financing. The purpose of deferring the sale of common stock is to (a) increase the leverage of the firm. (b) dilute the ownership interest. (c) minimize dilution in earnings per share. (d) time the sale of common stock when the price per share is basing. Answer: C Level of Difficulty: 2 Learning Goal: 3 Topic: Advantages of Convertibles
A convertible bond is almost always _________ with a call feature.
(a) a mortgage bond (b) an income bond (c) an equipment trust certificate (d) a debenture Answer: D Level of Difficulty: 2 Learning Goal: 3 Topic: Convertible Bonds
696 Gitman • Principles of Finance, Eleventh Edition 29. At the time of issuance, the issuer of a convertible security normally establishes a conversion price _________ the current market price of the firm’s stock. (a) below (b) equal to (c) above (d) unrelated to Answer: C Level of Difficulty: 2 Learning Goal: 3 Topic: Conversion Price
A _________ permits the firm’s capital structure to be changed without increasing the total financing. (a) put option (b) stock-purchase warrant (c) conversion feature (d) repurchase agreement Answer: C Level of Difficulty: 3 Learning Goal: 3 Topic: Conversion Features
Convertible bonds have all of the following characteristics EXCEPT
(a) conversion increases the firm’s debt ratio. (b) less expensive form of financing than straight bonds. (c) enhanced marketability. (d) a call feature. Answer: A Level of Difficulty: 3 Learning Goal: 3 Topic: Convertible Bonds
- Convertible preferred stock and convertible bonds are normally convertible over _________, respectively. (a) a limited time period and an unlimited time period (b) an unlimited time period and a limited time period (c) a limited time period and a limited time period (d) an unlimited time period and an unlimited time period Answer: B Level of Difficulty: 3 Learning Goal: 3 Topic: Convertible Preferred Stocks
Hybrid and Derivative Securities
Course: Accontancy (BSA)
University: Tarlac State University
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