Chapter 20, Problem 1Q

a.

Summary Introduction

To determine: Definition of preferred stocks

Introduction: Hybrid financing refers to the raising of funds to finance the operations of the business by using the instruments that carry the features of both common equity and the debt.

Explanation of Solution

Preferred stock is the financial instrument issued by the corporations in order to raise the long term funds at fixed dividend rate and preferential right is given to the holders in the payment of dividend over the common equity holders. The non-payment of dividend does not leads to bankruptcy of the company.

b.

Summary Introduction

To determine: Definition of cumulative dividends and arrearages.

Explanation of Solution

The preferred stockholders have the option to cumulate the dividend if they didn’t get the dividend in the year of losses. The cumulative dividend is the unpaid amount of dividend not paid in the years of losses and cumulate to the subsequent years till it get fully paid out of the profits of the company before making the payment to the common stockholders.

Arrearages refer to the amount of the preference dividend that is not paid to the holders and are in arrears.

c.   

Summary Introduction

To determine: Definition of warrant and detachable warrant.

Explanation of Solution

An option which entitles the holder with the right to buy a specified number of shares at the pre-stated price is known as warrant.

The warrant is attached to a security and the warrants that can be detached from the underlying security at the time of trading the warrants are known as detachable warrants.

d.

Summary Introduction

To determine: Definition of stepped-up price.

Explanation of Solution

Stepped-up price refers to the increase in the strike price of the underlying security of a warrant or option over the defined period of time. The securities with step-up price do not attract the investors and incorporated in the warrants so that the holders exercise them within the time period.

e.

Summary Introduction

To determine: Definition of convertible security.

Explanation of Solution

The option provided to the holders of certain bonds or preferred stock to convert their existing securities to the common stock after the expiry of a certain period. These bonds and preferred stock are known as the convertible securities.

f.

Summary Introduction

To determine: Definition of conversion ratio, conversion price and conversion value.

Explanation of Solution

The number of equity shares to be received by converting the one convertible security at the time of conversion is known as convertible ratio.

The price of the share that is effective at the time of conversion of the convertible security known as conversion price. It is the price for which the securities can be converted into the common stock.  It is calculating by dividing the par value of the security to be converted to the conversion ratio.

The conversion value refers to the financial value of the common stock that is received by the security holder at the time of the conversion of the security. It is calculated by multiplying the market price of each share and the conversion ratio.

g.

Summary Introduction

To determine: Definition of sweetener.

Explanation of Solution

The debt instruments are added with a feature in order to attract the investors to invest for lower yields by providing them the option either to convert their security to the common shares or purchase the shares at the lower price than that of market price. This feature of debt instruments is referred as the sweetener.