Question

1. Which of the following statements about convertibles is most CORRECT?

a.	One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted.
b.	Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
c.	At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stock's price.
d.	For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock.
e.	The coupon interest rate on a firm's convertibles is generally set higher than the market yield on its otherwise similar straight debt.

          

2. Which of the following statements concerning warrants is correct?

a.	Warrants are long-term put options that have value because holders can sell the firm's common stock at the exercise price regardless of how low the market price drops.
b.	Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen.
c.	A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.
d.	A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.
e.	Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock's price increases. However, if the option is exercised, the issuing company's debt declines if warrants were used but remains the same if it used convertibles.

          

3. Which of the following statements is most CORRECT?

a.	One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
b.	The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
c.	The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.
d.	Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
e.	Warrants have an option feature but convertibles do not.

4. Which of the following statements is most CORRECT?

a.	Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
b.	Defensive mergers are designed to make a company less vulnerable to a takeover.
c.	Hostile mergers always create value for the acquiring firm.
d.	In a tender offer, the target firm's management always remain after the merger is completed.
e.	A conglomerate merger is one where a firm combines with another firm in the same industry.

          

5. Which of the following statements is most CORRECT?

a.	The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.
b.	Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.
c.	Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.
d.	Operating economies are never a motive for mergers.
e.	Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

Answer 1

1) The statement no. (d) i.e (For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock) is correct.

Explanation :-

A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder.
As a hybrid security, the price of a convertible bond is especially sensitive to changes in interest rates, the price of the underlying stock, and the issuer's credit rating.
This bond's conversion ratio determines how many shares of stock you can get from converting one bond. For example, a 5:1 ratio means that one bond would convert to five shares of common stock.
The conversion price is the price per share at which a convertible security, such as corporate bonds or preferred shares, can be converted into common stock. The conversion price is set when the conversion ratio is decided for a convertible security.
Ideally, an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of remaining interest payments. However, due to the option to convert the bond into common stock, they offer a lower coupon rate. Companies like start up cos. benefit since they can issue debt at lower interest rates than with traditional bond offerings.

The rate of return on convertibles must be between expected return on common stock of the firm and the firm's straight debt because from the investor point of view investment on convertibles is more risky when compared with the straight debt so the expected rate of return always lies in between expected return of firm and return on straight debt of the firm. Most convertible bonds are considered to be riskier/more volatile than typical fixed-income instruments.

2) The statement (b) i.e. (Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen) is correct.

Explanation :-

Warrants and call options are both types of securities contracts. A warrant gives the holder the right, but not the obligation, to buy common shares of stock directly from the company at a fixed price for a pre-defined time period. Similarly, a call option also gives the holder the right, without the obligation, to buy a common share at a set price for a defined time period.
The guaranteed price at which the warrant or option buyer has the right to buy the underlying asset from the seller (technically, the writer of the call) is called the strike price/exercise price. “Exercise price” is the preferred term with reference to warrants.
the two basic components of value for a warrant and a call – intrinsic value and time value.
Intrinsic value for a warrant or call is the difference between the price of the underlying stock and the exercise or strike price. The intrinsic value can be zero, but it can never be negative. For example, if a stock trades at $10 and the strike price of a call on it is $8, the intrinsic value of the call is $2. If the stock is trading at $7, the intrinsic value of this call is zero. As long as the call option's strike price is lower than the market price of the underlying security, the call is considered being "in-the-money."
The higher the stock price, the higher the price or value of the call or warrant. Also, the lower the strike or exercise price, the higher the value of the call or warrant because any rational investor would pay more for the right to buy an asset at a lower price than a higher price.

Hence, we can conclude that warrants & call options are almost similar in nature.
The biggest benefit to retail investors of using warrants and calls is that they offer unlimited profit potential while restricting the possible loss to the amount invested. A buyer of a call option or warrant can only lose his premium, the price he paid for the contract.
Therefore, it can be said that warrants are long term call options that allow holders to buy the firm's common stock at the strike price regardless of how high the market price climbs.

3) The statement no. (b) (Defensive mergers are designed to make a company less vulnerable to a takeover) is correct.

Explanation :-

A defensive merger is a situation where a target organization wants to avoid acquisition by a particular takeover firm. For this to happen, the target organization chooses to merge with another organization so that they cannot be acquired by the initial acquisition firm.
Defensive mergers are a very difficult decision for a target firm's management. They have to choose between being acquired by an undesirable candidate or merging with what is usually their biggest competitor. The option to stay independent is often not possible because of the resources needed to stave off acquisition. Therefore, a defensive merger is typically the best option in order to retain some ownership while hopefully forming successful synergy with the merging firm.
A defensive merger is a strategy employed in the public markets rather than the private markets. A private middle market company that is approached by an undesirable acquiror will simply not pursue the transaction and will not be subject to the threat of a public market takeover or stock purchase.
After most takeovers, the managers of the acquired companies lose their jobs,or at least their autonomy.Therefore, the mangers who own less than 51% of their firm's stock look to devices that will lessen the chances of a takeover. Defensive mergers may also occur for mutual reasons if two cos. combine or exchange shares to prevent one being acquiredby a 3rd party. This control tactic is common among Asian cos. that lack widely dispersed shareholders.

4) The statement no. (c) (Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm) is correct.

Explanation :-

A diversified company is a type of company that has multiple unrelated businesses or products. Unrelated businesses are those that:

• Require unique management expertise
• Have different end customers
• Produce different products or provide different services

One of the benefits of being a diversified company is that it buffers a business from drastic fluctuations in any one industry sector. However, this model is also less likely to enable stockholders to realize significant gains or losses because it is not singularly focused on one business.
Companies may become diversified by entering into new businesses on its own by merging with another company or by acquiring a company operating in another field or service sector. One of the challenges facing diversified companies is the need to maintain a strong strategic focus to produce solid financial returns for shareholders instead of diluting corporate value through poorly managed acquisitions or expansions.
The argument that diversification benefits the shareholders by reducing volatility is not always true. At an aggregate level, conglomerates have underperformed more focused companies both in the real economy (i.e. in terms of growth and returns on capital) and in the stock market. Even adjusted for size differences, focused companies grew faster.
What matters in a diversification strategy is whether managers have the skills to add value to businesses in unrelated industries—by allocating capital to competing investments, managing their portfolios, or cutting costs.
Since, shareholders of publicly held companies can diversify their own personal portfolios. Corporate managers are not really needed to do this. Often managers getting into a new business just because it is growing fast or current profitability is high, is a risk that is best avoided. It has been seen that, opportunistic diversification has been the main reason for the downfall of several Indian entrepreneurs in various businesses including financial services, granite, aquaculture, and floriculture.