CFA Level 1 - Equity Investments Session 14 - Reading 50 (Notes, Practice Questions, Sample Questions) 1. Two seats on a board of directors are to be elected. A voting system in which the owner of 100 shares may cast 100 votes in each of the board elections is a: A)cumulative voting system.B)proportional voting system. C)statutory voting system Explanation — C: In a statutory voting system, a shareholder can vote in each separate board election based on the number of shares she owns. Undercumulative voting, the shareholder may choose to cast her total number of votes(200 in this example) for a candidate in one of the elections 2. An equity security that requires the ﬁrm to pay any scheduled dividends that have been missed, before paying any dividends to common equity holders, is a: A)cumulative preference share. B)participating preference share.C)convertible preference share Explanation — A: Cumulative preference shares (cumulative preferred stock) must receive any dividends in arrears before the ﬁrm may pay any dividends tocommon shareholders
3. Dividends on non-participating preference shares are typically: A)a contractual obligation of the company.B)lower than the dividends on common shares. C)a ﬁxed percentage of par value Explanation — C: Similar to the interest payments on a debt security, dividends on non-participating preference shares (preferred stock) are typically ﬁxed. Unlike theinterest payments on a debt security, the company is not contractually obligatedto pay preferred dividends. Preferred dividends are typically higher than a ﬁrm’scommon dividends 4. Participating preference shares most likely: A)can be exchanged for common stock at a ratio determined at issuance.B)give the shareholder the right to sell the shares back to the ﬁrm at a speciﬁc price. C)receive extra dividends if ﬁrm proﬁts exceed a predetermined threshold Explanation — C: Participating preference shares receive extra dividends if ﬁrm proﬁts exceed a predetermined threshold. Convertible preference shares can beexchanged for common stock at a conversion ratio determined at issuance.Putable common shares give the shareholder the right to sell the shares back tothe ﬁrm at a speciﬁc price 5. Compared to a publicly traded ﬁrm, a private equity ﬁrm is most likely to: A)be more concerned with short-term results.B)exhibit stronger corporate governance.
C)disclose less information about its ﬁnancial performance Explanation — C: Private equity ﬁrms are not held to the same ﬁnancial reporting requirements as publicly traded ﬁrms. Less public scrutiny and limited ﬁnance 6. Compared to a publicly traded ﬁrm, a private equity ﬁrm is most likely to: A)be more concerned with short-term results.B)exhibit stronger corporate governance. C)disclose less information about its ﬁnancial performance Explanation — C: Private equity ﬁrms are not held to the same ﬁnancial reporting requirements as publicly traded ﬁrms. Less public scrutiny and limited ﬁnancialdisclosure may lead to weaker corporate governance. However, with less pressurefrom public shareholders, a private equity ﬁrm is typically more able to focus onlong-term performance 7. Private equity securities most likely: A)trade in over-the-counter dealer markets. B)are illiquid and do not have quoted prices. C)are issued to individual investors. Explanation — B: Private equity securities are illiquid and do not trade in public securities markets. Holders of private equity must negotiate with other investorsto sell the securities. Private equity securities are typically issued to qualiﬁedinstitutional investors
8. Hodges Fund provides mezzanine stage ﬁnancing to private companies. In which type of private equity investing is Hodges Fund most likely involved? A)Leveraged buyout. B)Venture capital. C)Private investment in public equity. Explanation — B: Venture capital providers invest in ﬁrms that are early in their life cycles. Stages of venture capital ﬁnancing include seed stage, early stage, andmezzanine ﬁnancing. In a leveraged buyout, an investor purchases all of a publicﬁrm’s equity, taking the ﬁrm private. In a private investment in public equity (PIPE),an investor purchases private equity issued by a public ﬁrm 9. Liquidity of private equity is most likely: A)greater than liquidity of public equity.B)about equal to liquidity of public equity. C)less than liquidity of public equity. Explanation — C: Private equity securities are not registered to be traded in a public market, and therefore are less liquid that public equity 10. A security that represents an equity share in a foreign ﬁrm and for which the voting rights are retained by the depository bank, is a(n): A)unsponsored depository receipt. B)American depository share.C)global registered share
Explanation — A: In an unsponsored DR, the depository bank retains the voting rights of the equity shares of the foreign ﬁrm. In a sponsored DR, the investor inthe DR has the voting rights. For an American depository receipt, an Americandepository share is the underlying security that trades in the issuing ﬁrm’sdomestic market. A global registered share is an equity security that trades in thelocal currencies on stock exchanges around the world 11. Global depository receipts are most likely issued: A)outside the issuer’s home country and denominated in the exchange’s home currency. B)outside the issuer’s home country and denominated in U.S. dollars. C)in the United States and denominated in U.S. dollars Explanation — B: Global depository receipts are issued outside the U.S. and the issuer’s home country and are most often denominated in U.S. dollars. Depositoryreceipts issued in the United States and denominated in U.S. dollars are calledAmerican depository receipts. Global registered shares are denominated in thehome currencies of the exchanges on which they trade 12. Preference shares will have the most risk for the investor if the shares are: A)non-callable and non-cumulative.B)callable and cumulative. C)callable and non-cumulative Explanation — C: Preference shares (preferred stock) has more risk for the investor if they are non-cumulative than if they are cumulative, because withcumulative preference shares the ﬁrm must pay the holder any omitted dividendsbefore it can pay any dividends to common shareholders. Callable shares have
more risk for the investor than non-callable shares because the call option limitstheir potential for price appreciation 13. Other things equal, which of the following types of stock has the most risk from the investor’s perspective? A)Callable preferred share.B)Callable common share. C)Putable common share Explanation — C: Callable shares have more risk than putable shares because the issuer can exercise the call option (which limits the investor’s potential gains)while the investor can exercise the put option (which limits the investor’s potentiallosses, assuming the ﬁrm is able to meet its obligation). Preferred shares haveless risk for the investor than common shares because preferred shares have ahigher priority claim on the ﬁrm’s assets in the event of liquidation, and becausepreferred dividends typically must be paid before common dividends may be paid 14. The primary reason for a ﬁrm to issue equity securities is to: A)improve its solvency ratios.B)increase publicity for the ﬁrm’s products. C)acquire the assets necessary to carry out its operations Explanation — C: While issuing equity securities can improve a company’s solvency ratios and increase the ﬁrm’s visibility with the public, the primaryreason to issue equity is to raise the capital needed to acquire operating assets
15. Pearl River Heavy Industries shows the following information in its ﬁnancial statements:Total Assets HK$146,000,000Total Liabilities HK$87,000,000Net Income HK$27,000,000Price per Share HK$312Shares Outstanding 200,000 The equity securities of Pearl River have a: A)book value of HK$62,400,000.B)market value of HK$146,000,000. C)book value of HK$59,000,000. Explanation — C: Book value = Total assets − total liabilities = 146,000,000 − 87,000,000 = HK$59,000,000Market value of equity = Market price per share × shares outstanding = HK$312 ×200,000 = HK$62,400,000