1) The par value of a common stock represents

A. The estimated market value of the stock when it was issued.

B. The liability ceiling of a shareholder when a company undergoes bankruptcy proceedings.
C. The total value of the stock that must be entered in the issuing corporation’s records.
D. A theoretical value of $100 per share of stock with any differences entered in the issuing corporation’s records
as discount or premium on common stock.

A. The estimated market value of the stock when it was issued.

Answer (A) is incorrect.
Par value is rarely the same as market value. Normally, market value will be equal to or greater than
par value, but there is no relationship between the two.

B. The liability ceiling of a shareholder when a company undergoes bankruptcy proceedings.

Answer (B) is correct.
Par value represents a stock’s legal capital. It is an arbitrary value assigned to stock before it is
issued. Par value represents a shareholder’s liability ceiling because, as long as the par value has
been paid in to the corporation, the shareholders obtain the benefits of limited liability.

The total value of the stock that must be entered in the issuing corporation’s records.
C.
Answer (C) is incorrect.
All assets received for stock must be entered into a corporation’s records. The amount received is
very rarely the par value.

D. A theoretical value of $100 per share of stock with any differences entered in the issuing
corporation’s records as discount or premium on common stock.
Answer (D) is incorrect.
Par value can be any amount more or less than $100.

2) Which one of the following rights is ordinarily sacrificed by the holders of preferred stock in
exchange for other preferences received over common shareholders?

A. The right to vote for members of the board of directors and in other matters requiring a vote.
B. The right to share in the residual assets of the company upon liquidation.
C. The right to share in the periodic earnings of the company through the receipt of dividends.
D. The right to accrue dividend payments in arrears when payments are not made for a period of time.
A. The right to vote for members of the board of directors and in other matters requiring a vote.
Answer (A) is correct.
Unlike common stockholders, preferred stockholders are not usually entitled to voting rights.
Preferred stockholders sacrifice voting rights in exchange for other preferences over common
stockholders.

The right to share in the residual assets of the company upon liquidation.
B.
Answer (B) is incorrect.
Preferred stock holders have priority in assets and earnings. If the firm goes bankrupt, the preferred
shareholders have priority over common shareholders.

C. The right to share in the periodic earnings of the company through the receipt of dividends.
Answer (C) is incorrect.
Preferred stockholders receive their dividends before the common stockholders receive theirs.

D. The right to accrue dividend payments in arrears when payments are not made for a period of time.
Answer (D) is incorrect.
Forgone dividends accumulate and must eventually be paid to preferred shareholders.

3) The following excerpt was taken from a company’s financial statements: “ . . . 10% convertible
participating . . . $10,000,000.” What is most likely being referred to?

A. Bonds.
B. Common stock.
C. Stock options.
D. Preferred stock.

Bonds.
A.
Answer (A) is incorrect.
Bonds normally have a coupon yield stated in percentage and may be convertible but are not
participating.

B. Common stock.
Answer (B) is incorrect.
Common stock is not described as convertible or participating on the financial statements.

C. Stock options.
Answer (C) is incorrect.
Common stock options are not participating and do not have a stated yield rate.

Preferred stock.
D.
Answer (D) is correct.
Preferred shareholders have priority over common shareholders in the assets and earnings of the
enterprise. If preferred dividends are cumulative, any past preferred dividends must be paid before
any common dividends. Preferred stock may also be convertible into common stock, and it may be
participating. For example, 10% fully participating preferred stock will receive additional distributions
at the same rates as other shareholders if dividends paid to all shareholders exceed 10%.

4) In general, it is more expensive for a company to finance with equity capital than with debt
capital because

A. Long-term bonds have a maturity date and must therefore be repaid in the future.
B. Investors are exposed to greater risk with equity capital.
C. Equity capital is in greater demand than debt capital.
D. Dividends fluctuate to a greater extent than interest rates.

A. Long-term bonds have a maturity date and must therefore be repaid in the future.
Answer (A) is incorrect.
The obligation to repay at a specific maturity date reduces the risk to investors and thus the required
return.

B. Investors are exposed to greater risk with equity capital.

Answer (B) is correct.
Providers of equity capital are exposed to more risk than are lenders because the firm is not
obligated to pay them a return. Also, in case of liquidation, creditors are paid before equity investors.
Thus, equity financing is more expensive than debt because equity investors require a higher return
to compensate for the greater risk assumed.

Equity capital is in greater demand than debt capital.

C.
Answer (C) is incorrect.
The demand for equity capital is directly related to its greater cost to the issuer.
D. Dividends fluctuate to a greater extent than interest rates.
Answer (D) is incorrect.
Dividends are based on managerial discretion and may rarely change; interest rates, however,
fluctuate daily based upon market conditions.

5) The equity section of a Statement of Financial Position is presented below.

Preferred stock, $100 par $12,000,000

Common stock, $5 par 10,000,000

Paid-in capital in excess of par 18,000,000

Retained earnings 9,000,000

Net worth $49,000,000

The common shareholders have preemptive rights. If an additional 400,000 shares of common
stock are issued at $6 per share, a current holder of 20,000 shares of common stock must be
given the option to buy

A. 1,000 additional shares.

B. 3,774 additional shares.
C. 4,000 additional shares.
D. 3,333 additional shares.

A. 1,000 additional shares.

Answer (A) is incorrect.
To arrive at 1,000 additional shares, the number of shares currently outstanding was incorrectly
calculated as 8,000,000 [($12,000,000 + $10,000,000 + $18,000,000) ÷ $5].

3,774 additional shares.

B.
Answer (B) is incorrect.
The investor would be allowed to purchase 1% of any new issues.
C. 4,000 additional shares.
Answer (C) is correct.
Common shareholders usually have preemptive rights, which means they have first right to
purchase any new issues of stock in proportion to their current ownership percentages. The purpose
of a preemptive right is to allow stockholders to maintain their current percentages of ownership.
Given that the corporation had 2,000,000 shares outstanding ($10,000,000 ÷ $5 par), an investor
with 20,000 shares has a 1% ownership. Thus, this investor must be allowed to purchase 4,000
(400,000 shares × 1%) of the additional shares.

D. 3,333 additional shares.

Answer (D) is incorrect.
The investor would be allowed to purchase 1% of any new issues.

6) A financial manager usually prefers to issue preferred stock rather than debt because

A. Payments to preferred stockholders are not considered fixed payments.

B. The cost of fixed debt is less expensive since it is tax deductible even if a sinking fund is required to retire the
debt.
C. The preferred dividend is often cumulative, whereas interest payments are not.
D. In a legal sense, preferred stock is equity; therefore, dividend payments are not legal obligations.

A. Payments to preferred stockholders are not considered fixed payments.

Answer (A) is incorrect.
Preferred dividends are viewed as fixed payments since they must be made before any dividends or
distributions in liquidation can be made to common shareholders.

B. The cost of fixed debt is less expensive since it is tax deductible even if a sinking fund is required to
retire the debt.
Answer (B) is incorrect.
It states a reason to issue debt, not preferred stock.

The preferred dividend is often cumulative, whereas interest payments are not.
C.
Answer (C) is incorrect.
In the sense that they cannot be avoided, interest payments are cumulative.
In a legal sense, preferred stock is equity; therefore, dividend payments are not legal obligations.
D.
Answer (D) is correct.
For a financial manager, preferred stock is preferable to debt because dividends do not have to be
paid on preferred stock, but failure to pay interest on debt could lead to bankruptcy. Thus, preferred
stock is less risky than debt. However, debt has some advantages over preferred stock, the most
notable of which is that interest payments are tax deductible. Preferred stock dividends are not.

7) Which one of the following situations would prompt a firm to issue debt, as opposed to equity,
the next time it raises external capital?

A. High breakeven point.

B. Significant percentage of assets under capital lease.
C. Low fixed-charge coverage.
D. High effective tax rate.

High breakeven point.

A.
Answer (A) is incorrect.
A high breakeven point is a sign that the firm is already highly leveraged.

Significant percentage of assets under capital lease.

B.
Answer (B) is incorrect.
Having a significant percentage of assets under capital lease does not affect the debt vs. equity
decision.

C. Low fixed-charge coverage.

Answer (C) is incorrect.
Having a low fixed-charge coverage does not affect the debt vs. equity decision.

High effective tax rate.

D.
Answer (D) is correct.
The interest paid on indebtedness is deductible for tax purposes; dividends paid to equity holders is
not. Thus, a firm with a high effective tax rate would prefer to issue debt, which would create an
additional tax benefit.
8) Preferred and common stock differ in that

A. Failure to pay dividends on common stock will not force the firm into bankruptcy, while failure to pay
dividends on preferred stock will force the firm into bankruptcy.
B. Common stock dividends are a fixed amount, while preferred stock dividends are not.
C. Preferred stock has a higher priority than common stock with regard to earnings and assets in the event of
bankruptcy.
D. Preferred stock dividends are deductible as an expense for tax purposes, while common stock dividends are
not.

A. Failure to pay dividends on common stock will not force the firm into bankruptcy, while failure to pay
dividends on preferred stock will force the firm into bankruptcy.
Answer (A) is incorrect.
Failure to pay dividends will not force the firm into bankruptcy, whether the dividends are for
common or preferred stock. Only failure to pay interest will force the firm into bankruptcy.

B. Common stock dividends are a fixed amount, while preferred stock dividends are not.
Answer (B) is incorrect.
Preferred dividends are fixed.

C. Preferred stock has a higher priority than common stock with regard to earnings and assets in the
event of bankruptcy.
Answer (C) is correct.
In the event of bankruptcy, the claims of preferred shareholders must be satisfied before common
shareholders receive anything. The interests of common shareholders are secondary to those of all
other claimants.

Preferred stock dividends are deductible as an expense for tax purposes, while common stock
D. dividends are not.
Answer (D) is incorrect.
Neither common nor preferred dividends are tax deductible.

9) Unless the shares are specifically restricted, a holder of common stock with a preemptive right
may share proportionately in all of the following except

A. The vote for directors.

B. Corporate assets upon liquidation.
C. Cumulative dividends.
D. New issues of stock of the same class.

A. The vote for directors.

Answer (A) is incorrect.
Common shareholders have the right to vote (although different classes of shares may have
different privileges).

B. Corporate assets upon liquidation.

Answer (B) is incorrect.
Common shareholders have the right to share proportionately in corporate assets upon liquidation
(but only after other claims have been satisfied).

C. Cumulative dividends.
Answer (C) is correct.
Common stock does not have the right to accumulate unpaid dividends. This right is often attached
to preferred stock.

D. New issues of stock of the same class.

Answer (D) is incorrect.
Common shareholders have the right to share proportionately in any new issues of stock of the
same class (the preemptive right).

10) Which of the following is usually not a feature of cumulative preferred stock?

A. Has priority over common stock with regard to earnings.

B. Has priority over common stock with regard to assets.
C. Has voting rights.
D. Has the right to receive dividends in arrears before common stock dividends can be paid.

A. Has priority over common stock with regard to earnings.

Answer (A) is incorrect.
Preferred stock has priority over common stock with regard to earnings, so dividends must be paid
on preferred stock before they can be paid on common stock.
Has priority over common stock with regard to assets.
B.
Answer (B) is incorrect.
Preferred stock has priority over common stock with regard to assets. In the event of liquidation, for
example, because of bankruptcy, the claims of preferred shareholders must be satisfied in full
before the common shareholders receive anything.

C. Has voting rights.

Answer (C) is correct.
Preferred stock does not usually have voting rights. Preferred shareholders are usually given the
right to vote for directors only if the company has not paid the preferred dividend for a specified
period of time, such as ten quarters. Such a provision is an incentive for management to pay
preferred dividends.

D. Has the right to receive dividends in arrears before common stock dividends can be paid.
Answer (D) is incorrect.
Cumulative preferred stock has the right to receive any dividends not paid in prior periods before
common stock dividends are paid.

11) Which one of the following statements is correct regarding the effect preferred stock has on a
company?

A. The firm’s after-tax profits are shared equally by common and preferred shareholders.
B. Control of the firm is now shared by the common and preferred shareholders, with preferred shareholders
having greater control.
C. Preferred shareholders’ claims take precedence over the claims of common shareholders in the event of
liquidation.
D. Nonpayment of preferred dividends places the firm in default, as does nonpayment of interest on debt.

A. The firm’s after-tax profits are shared equally by common and preferred shareholders.
Answer (A) is incorrect.
The share of profits available to preferred stockholders is normally limited to a percentage of the
stock’s par value. Thus, they may get more or less than the common shareholders.

B. Control of the firm is now shared by the common and preferred shareholders, with preferred
shareholders having greater control.
Answer (B) is incorrect.
Preferred stockholders ordinarily do not have voting rights.

Preferred shareholders’ claims take precedence over the claims of common shareholders in the
C. event of liquidation.
Answer (C) is correct.
Preferred stockholders have preference over common stockholders with respect to dividend and
liquidation rights, but payment of preferred dividends, unlike bond interest is not mandatory. In
exchange for these preferences, the preferred stockholders give up the right to vote. Consequently,
preferred stock is a hybrid of debt and equity.

Nonpayment of preferred dividends places the firm in default, as does nonpayment of interest on
D. debt.
Answer (D) is incorrect.
The passing of preferred dividends does not put the corporation into default. For this reason,
preferred stock is sometimes viewed more favorably than debt by corporate management. If the
preferred stock is cumulative (which most is), the corporation may not pay dividends to common
shareholders until the arrearages to preferred stockholders have been paid.

12) Preferred stock may be retired through the use of any one of the following except a

A. Conversion.
B. Call provision.
C. Refunding.
D. Sinking fund.

A. Conversion.
Answer (A) is incorrect.
Preferred stock can be issued with a conversion feature.

Call provision.
B.
Answer (B) is incorrect.
Preferred stock can be issued with a call provision.

C. Refunding.
Answer (C) is correct.
Preferred stock is equity. Only debt can be refunded.

D. Sinking fund.
Answer (D) is incorrect.
A sinking fund can be established for preferred stock.

13) All of the following are characteristics of preferred stock except that

A. It may be callable at the option of the corporation.

B. It may be converted into common stock.
C. Its dividends are tax deductible to the issuer.
D. It usually has no voting rights.

A. It may be callable at the option of the corporation.

Answer (A) is incorrect.
Preferred stock can be issued with a call provision.

B. It may be converted into common stock.

Answer (B) is incorrect.
Preferred stock can be issued with a conversion feature.

C. Its dividends are tax deductible to the issuer.

Answer (C) is correct.
Dividends on stock, whether common or preferred, are not deductible for tax purposes.

D. It usually has no voting rights.

Answer (D) is incorrect.
Preferred stock can be issued with voting rights attached.

14) Which one of the following describes a disadvantage to a firm that issues preferred stock?

A. Preferred stock dividends are legal obligations of the corporation.

B. Preferred stock typically has no maturity date.
C. Preferred stock is usually sold on a higher yield basis than bonds.
D. Most preferred stock is owned by corporate investors.

A. Preferred stock dividends are legal obligations of the corporation.

Answer (A) is incorrect.
No dividends, even on cumulative preferred stock, are legal obligations of the corporation until they
are declared.

B. Preferred stock typically has no maturity date.

Answer (B) is incorrect.
Preferred stock is a form of equity, i.e., ownership. The lack of a maturity date is one of the
strengths of preferred stock from the issuer’s standpoint.

Preferred stock is usually sold on a higher yield basis than bonds.

C.
Answer (C) is correct.
Preferred stock must usually be sold on a higher yield basis than bonds because preferred stock
stands behind bonds in priority at liquidation. An incentive must therefore be added to induce
investors to purchase preferred stock. Since preferred stock is a riskier investment than bonds,
investors demand a risk premium.

D. Most preferred stock is owned by corporate investors.

Answer (D) is incorrect.
It is of no importance to the corporation whether its preferred stock is owned by other corporations
or by private parties.

15) Each share of nonparticipating, 8%, cumulative preferred stock in a company that meets its
dividend obligations has all of the following characteristics except

A. Voting rights in corporate elections.

B. Dividend payments that are not tax deductible by the company.
C. No principal repayments.
D. A superior claim to common stock equity in the case of liquidation.
Voting rights in corporate elections.
A.
Answer (A) is correct.
Dividends on cumulative preferred stock accrue until declared; that is, the book value of the
preferred stock increases by the amount of any undeclared dividends. Participating preferred stock
participates with common shareholders in excess earnings of the company. In other words, 8%
participating preferred stock might pay a dividend each year greater than 8% when the corporation
is extremely profitable. Therefore, nonparticipating preferred stock will receive no more than is
stated on the face of the stock. Preferred shareholders rarely have voting rights. Voting rights are
exchanged for preferences regarding dividends and liquidation of assets.

B. Dividend payments that are not tax deductible by the company.

Answer (B) is incorrect.
A corporation does not receive a tax deduction for making dividend payments on any type of stock.

C. No principal repayments.
Answer (C) is incorrect.
Preferred stock normally need not be redeemed as long as the corporation remains in business.

A superior claim to common stock equity in the case of liquidation.

D.
Answer (D) is incorrect.
Preferred shareholders do have priority over common shareholders in a liquidation.