[WILEY FINRA SERIES]VAN BLARCOM, JEFF -Wiley Series 65 Exam Review 2016 + TEST BANK The Uniform Investment Advisor Law Exam

[WILEY FINRA SERIES]VAN BLARCOM, JEFF -Wiley Series 65 Exam Review 2016 + TEST BANK The Uniform Investment Advisor Law Exam Contents ABOUT THE SERIES 65 EXAM xxi ABOUT THIS BOOK xxv ABOUT THE TEST BANK xxvii ABOUT THE SECURITIES INSTITUTE OF AMERICA xxix CHAPTER 1 EQUITY SECURITIES 1 What Is a Security? 1 Equity = Stock 2 Common Stock 2 Corporate Time Line 2 Values of Common Stock 4 Book Value 4 Par Value 5 Rights of Common Stockholders 5 Preemptive Rights 5 Characteristics of a Rights Offering 6 Determining the Value of a Right Cum Rights 7 Determining the Value of a Right Ex Rights 7 Voting 8 vi Contents Limited Liability 9 Freely Transferable 9 The Transfer Agent 10 The Registrar 10 CUSIP Numbers 11 Inspection of Books and Records 11 Residual Claim to Assets 11 Why Do People Buy Common Stock? 11 Income 11 What Are the Risks of Owning Common Stock? 12 How Does Someone Become a Stockholder? 13 Preferred Stock 14 Features of All Preferred Stock 14 Types of Preferred Stock 16 Callable Preferred 17 Types of Dividends 17 Dividend Distribution 18 Taxation of Dividends 20 Selling Dividends 20 Dividend Disbursement Process 21 Warrants 21 How Do People Get Warrants? 21 American Depositary Receipts (ADRs)/American Depositary Shares (ADSs) 22 Currency Risks 23 Functions of the Custodian Bank Issuing ADRs 23 Real Estate Investment Trusts/REITs 23 Direct Participation Programs and Limited Partnerships 24 Limited Partnerships 24 Tax Reporting for Direct Participation Programs 28 Limited Partnership Analysis 28 Tax Deductions vs. Tax Credits 28 Other Tax Considerations 29 Dissolving a Partnership 29 Pretest 31 Contents vii CHAPTER 2 CORPORATE AND MUNICIPAL DEBT SECURITIES 35 Corporate Bonds 35 Types of Bond Issuance 36 Bond Pricing 37 Par Value 38 Discount 38 Premium 38 Corporate Bond Pricing 38 Bond Yields 39 Yield to Maturity: Premium Bond 40 Yield to Maturity: Discount Bond 41 Calculating the Yield to Maturity 41 Calculating the Yield to Call 42 Realized Compound Yield Returns 42 Yield Spreads 43 The Real Interest Rate 43 Bond Maturities 43 Series Issue 44 Types of Corporate Bonds 44 Guaranteed Bonds 46 Convertible Bonds 46 Converting Bonds into Common Stock 47 Parity Price 47 Advantages of Issuing Convertible Bonds 48 Disadvantages of Issuing Convertible Bonds 48 Convertible Bonds and Stock Splits 48 The Trust Indenture Act of 1939 49 Bond Indenture 49 Ratings Considerations 49 Exchange Traded Notes (ETNs) 50 Euro and Yankee Bonds 50 Variable Rate Securities 51 Retiring Corporate Bonds 51 Municipal Bonds 53 Types of Municipal Bonds 54 Taxation of Municipal Bonds 58 Tax-Equivalent Yield 58 Purchasing a Municipal Bond Issued in the State in Which the Investor Resides 59 Triple Tax Free 59 Original Issue Discount (OID) and Secondary Market Discounts 59 Amortization of a Municipal Bond’s Premium 60 Bond Swaps 60 Analyzing Municipal Bonds 60 Analyzing General Obligation Bonds 61 Duration 61 Convexity 62 Bond Portfolio Management 62 Pretest 65 CHAPTER 3 GOVERNMENT AND GOVERNMENT AGENCY ISSUES 69 Series EE Bonds 69 Series HH Bonds 70 Treasury Bills, Notes, and Bonds 70 Purchasing Treasury Bills 70 Treasury Notes 71 Treasury Bonds 71 Treasury Bond and Note Pricing 71 Treasury STRIPs 72 Treasury Receipts 72 Treasury Inflation Protected Securities (TIPS) 73 Agency Issues 74 Government National Mortgage Association (GNMA) 74 Federal National Mortgage Association (FNM) 75 Federal Home Loan Mortgage Corporation (FHLMC) 75 Federal Farm Credit System 76 Collateralized Mortgage Obligation (CMO) 76 viii Contents CMOs and Interest Rates 76 Types of CMOs 77 Pretest 79 CHAPTER 4 INVESTMENT COMPANIES 81 Investment Company Philosophy 81 Types of Investment Companies 82 Open End vs. Closed End 83 Diversified vs. Nondiversified 84 Investment Company Registration 85 Registration Requirements 85 Investment Company Components 87 Mutual Fund Distribution 89 Selling Group Member 89 Distribution of No-Load Mutual Fund Shares 90 Distribution of Mutual Fund Shares 90 Mutual Fund Prospectus 90 Characteristics of Open-End Mutual Fund Shares 91 Mutual Fund Investment Objectives 92 Other Types of Funds 94 Bond Funds 94 Alternative Funds 96 Valuing Mutual Fund Shares 96 Sales Charges 98 Other Types of Sales Charges 100 Recommending Mutual Funds 100 Calculating a Mutual Fund’s Sales Charge Percentage 101 Finding the Public Offering Price 102 Sales Charge Reductions 102 Breakpoint Schedule 103 Letter of Intent 103 Breakpoint Sales 104 Rights of Accumulation 104 Contents ix Automatic Reinvestment of Distributions 105 Other Mutual Fund Features 105 Dollar Cost Averaging 106 Mutual Funds Voting Rights 108 Mutual Fund Yields 109 Portfolio Turnover 109 Pretest 111 CHAPTER 5 VARIABLE ANNUITIES AND RETIREMENT PLANS 115 Annuities 115 Bonus Annuity 117 Equity-Indexed Annuity 118 Recommending Variable Annuities 119 Annuity Purchase Options 120 Accumulation Units 121 Annuity Units 121 Annuity Payout Options 122 Factors Affecting the Size of the Annuity Payment 123 The Assumed Interest Rate (AIR) 123 Taxation 124 Types of Withdrawals 124 Annuitizing the Contract 125 Sales Charges 125 Investment Management Fees 125 Variable Annuity vs. Mutual Fund 125 Retirement Plans 126 Individual Plans 126 Individual Retirement Accounts (IRAs) 126 Corporate Plans 135 Types of Plans 136 Rolling Over a Pension Plan 138 Employee Stock Options 138 x Contents Employee Retirement Income Security Act of 1974 (ERISA) 139 Erisa 404C Safe Harbor 140 Life Insurance 141 Tax Implications of Life Insurance 143 Pretest 145 CHAPTER 6 FUNDAMENTAL AND TECHNICAL ANALYSIS 149 Fundamental Analysis 149 Balance Sheet 150 Capitalization 152 Changes in the Balance Sheet 152 The Income Statement 156 Industry Fundamentals 158 Top-Down and Bottom-Up Analysis 158 Dividend Valuation Models 159 Technical Analysis 159 Market Theories and Indicators 163 Efficient Market Theory 164 Statistical Analysis 165 Market Capitalization 166 Pretest 167 CHAPTER 7 ECONOMIC FUNDAMENTALS 169 Gross Domestic Product 169 Recession 171 Depression 171 Economic Indicators 171 Schools of Economic Thought 173 Economic Policy 174 Tools of the Federal Reserve Board 174 Interest Rates 174 Contents xi Reserve Requirement 176 Changing the Discount Rate 176 Federal Open Market Committee 176 Money Supply 177 Disintermediation 178 Moral Suasion 178 Fiscal Policy 178 International Monetary Considerations 180 London Interbank Offered Rate / Libor 180 Yield Curve Analysis 181 Pretest 183 CHAPTER 8 RECOMMENDATIONS, PROFESSIONAL CONDUCT, AND TAXATION 187 Professional Conduct by Investment Advisers 188 The Uniform Prudent Investors Act of 1994 188 Fair Dealings with Clients 189 Recommending Mutual Funds 193 Periodic Payment Plans 193 Disclosure of Client Information 194 Borrowing and Lending Money 194 Developing the Client Profile 194 Types of Advisory Clients 195 Investment Objectives 200 Capital Asset Pricing Model (CAPM) 202 Risk vs. Reward 203 Alpha 205 Beta 205 Expected Return 206 Time Value of Money 207 Weighted Returns 209 Modern Portfolio Theory 211 xii Contents Predicting Portfolio Income 212 Tax Structure 214 Investment Taxation 214 Calculating Gains and Losses 214 Cost Base of Multiple Purchases 215 Deducting Capital Losses 216 Wash Sales 216 Taxation of Interest Income 217 Inherited and Gifted Securities 217 Donating Securities to Charity 217 Trusts 218 Gift Taxes 220 Estate Taxes 220 Withholding Tax 221 Corporate Dividend Exclusion 221 Alternative Minimum Tax (AMT) 221 Taxes on Foreign Securities 221 Pretest 223 CHAPTER 9 SECURITIES INDUSTRY RULES AND REGULATIONS 227 The Securities Act of 1933 227 The Prospectus 228 The Final Prospectus 228 SEC Disclaimer 229 Misrepresentations 229 The Securities Exchange Act of 1934 230 The Securities Exchange Commission (SEC) 230 Extension of Credit 231 Public Utilities Holding Company Act of 1935 231 Financial Industry Regulatory Authority (FINRA) 231 The Trust Indenture Act of 1939 232 Contents xiii Investment Advisers Act of 1940 232 Investment Company Act of 1940 233 FINRA Member Communications with the Public 233 FINRA Rule 2210 Communications with the Public 234 Corporate Websites 236 Blind Recruiting Ads 237 Generic Advertising 237 Tombstone Ads 238 Testimonials 238 Free Services 239 Misleading Communications 240 Securities Investor Protection Corporation Act of 1970 (SIPC) 240 Net Capital Requirement 240 Customer Coverage 241 Fidelity Bond 241 The Securities Acts Amendments of 1975 242 The Insider Trading and Securities Fraud Enforcement Act of 1988 242 Firewall 243 The Telephone Consumer Protection Act of 1991 243 Exemption from the Telephone Consumer Protection Act of 1991 244 National Securities Market Improvement Act of 1996 244 The Uniform Securities Act 245 Currency Transactions 245 The Patriot Act 246 Pretest 249 CHAPTER 10 TRADING SECURITIES 253 Types of Orders 253 The Exchanges 257 Priority of Exchange Orders 257 The Role of the Specialist/DMM 257 The Specialist/DMM Acting as a Principal 258 xiv Contents The Specialist/DMM Acting as an Agent 258 Crossing Stock 260 Do Not Reduce (DNR) 261 Adjustments for Stock Splits 261 Stopping Stock 262 Commission House Broker 263 Two-Dollar Broker 263 Registered Traders 263 Super Display Book (SDBK) 263 Short Sales 264 Regulation of Short Sales/Regulation SHO 264 Rule 200 Definitions and Order Marking 264 Rule 203 Security Borrowing and Delivery Requirements 265 Over the Counter/Nasdaq 266 Market Makers 267 Nasdaq Subscription Levels 267 Nasdaq Quotes 268 Nominal Nasdaq Quotes 269 Nasdaq Execution Systems 269 Nasdaq Market Center Execution System (NMCES) 269 Nasdaq Opening Cross 270 Non-Nasdaq OTCBB 270 Pink OTC 270 Third Market 270 Fourth Market 271 Broker vs. Dealer 271 FINRA 5% Markup Policy 272 Markups/Markdowns When Acting as a Principal 272 Riskless Principal Transactions 273 Proceeds Transactions 274 Arbitrage 274 Pretest 275 Contents xv CHAPTER 11 OPTIONS 279 Option Classification 279 Option Classes 280 Option Series 280 Bullish vs. Bearish 280 Possible Outcomes for an Option 281 Characteristics of All Options 282 Managing an Option Position 282 Buying Calls 283 Maximum Gain Long Calls 283 Maximum Loss Long Calls 283 Determining the Breakeven for Long Calls 284 Selling Calls 284 Buying Puts 286 Selling Puts 287 Option Premiums 289 In-the-Money Options 289 At-the-Money Options 289 Out-of-the-Money Options 290 Intrinsic Value and Time Value 290 Using Options as a Hedge 291 Long Stock Long Puts/Married Puts 291 Long Stock Short Calls/Covered Calls 293 Short Stock Long Calls 295 Short Stock Short Puts 298 Futures and Forwards 301 Correlation 301 Pretest 303 CHAPTER 12 DEFINITION OF TERMS 307 Security 307 Person 309 xvi Contents Broker Dealer 310 Agent 311 Issuer 311 Nonissuer 312 Investment Adviser 312 Pension Consultants 312 Investment Counsel 313 Form ADV 313 Investment Adviser Registration Database IARD 314 Investment Adviser Representative 315 Solicitor 315 Access Person 315 Institutional Investor 316 Accredited Investor 316 Qualified Purchaser 317 Private Investment Company 317 Offer/Offer to Sell/Offer to Buy 317 Sale/Sell 317 Guarantee/Guaranteed 318 Contumacy 318 Federally Covered Exemption 318 Power of Attorney 319 Negotiable Certificate of Deposit 319 Pretest 321 CHAPTER 13 REGISTRATION OF BROKER DEALERS, INVESTMENT ADVISERS, AND AGENTS 327 Registration of Broker Dealers and Agents 327 Changes in an Agent’s Employment 332 Mergers and Acquisitions of Firms 332 Renewing Registrations 332 Canadian Firms and Agents 332 Investment Adviser Registration 333 Contents xvii Advertising and Sales Literature 337 Brochure Delivery 338 The Role of the Investment Adviser 339 Additional Compensation for an Investment Adviser 339 Agency Cross Transactions 340 Disclosures by an Investment Adviser 340 Investment Adviser Contracts 343 Additional Roles of Investment Advisers 343 Private Investment Companies/Hedge Funds 344 Fulcrum Fees 344 Wrap Accounts 344 Soft Dollars 344 Pretest 347 CHAPTER 14 SECURITIES REGISTRATION, EXEMPT SECURITIES, AND EXEMPT TRANSACTIONS 353 Exempt Securities 353 Securities Registration 354 Exempt Securities/Federally Covered Exemption 357 Exempt Transactions 358 Private Placements/Regulation D Offerings 358 RULE 144 359 RULE 147 Intrastate Offering 360 Transactions with Financial Institutions 360 Transactions with Fiduciaries 361 Transactions with Underwriters 361 Unsolicited Orders 361 Transactions in Mortgage-Backed Securities 361 Pledges 362 Offers to Existing Securities Holders 362 Preorganization Certificates 362 Isolated Nonissuer Transactions 362 xviii Contents Nonissuer Transactions 363 Pretest 365 CHAPTER 15 STATE SECURITIES ADMINISTRATOR: THE UNIFORM SECURITIES ACT 369 North America Securities Administrators Association 369 Actions by the State Securities Administrator 370 Cancelation of a Registration 371 Withdrawal of a Registration 371 Actions Against an Issuer of Securities 371 Rule Changes 372 Administrative Orders 372 Interpretive Opinions 373 Administrative Records 373 Investigations 374 Civil and Criminal Penalties 374 Jurisdiction of the State Securities Administrator 375 Administrator’s Jurisdiction over Securities Transactions 376 Radio, Television, and Newspaper Distribution 378 Right of Rescission 378 Statute of Limitations 379 Pretest 381 ANSWER KEYS 387 GLOSSARY OF EXAM TERMS 401 INDEX 467 Contents xix About the Series 65 Exam Congratulations! You are on your way to becoming licensed as an investment adviser in all states that require the Series 65 license. The Series 65 exam will be presented in a 130-question multiple-choice format. Each candidate will have three hours to complete the exam. A score of 72% or higher is required to pass. The Series 65 is as much a knowledge test as it is a reading test. The writers and instructors at The Securities Institute have developed the Series 65 textbook, exam prep software, and videos to ensure that you have the knowledge required to pass the test, and to make sure that you are confident in the application of the knowledge during the exam. The writers and instructors at The Securities Institute are subject-matter experts as well as Series 65 test experts. We understand how the test is written and our proven test-taking techniques can dramatically improve your results. TAKING THE SERIES 65 EXAM The Series 65 exam is presented in multiple-choice format on a touch-screen computer known as the PROCTOR system. No computer skills are required and candidates will find that the test screen works in the same way as an ordinary ATM machine. Each test is made up of 130 questions that are randomly chosen from a test bank of several thousand questions. The test has a time limit of three hours and is designed to provide enough time for all candidates to complete the exam. Each Series 65 exam will have 10 additional questions that do not count toward the final score. The Series 65 exam comprises questions that focus on the following areas: xxii WILEY SERIES 65 Exam Review 2016 Ethics and legal guidelines 40 questions 31% Investment strategies 40 questions 31% Investment vehicles 31 questions 24% Economics and analysis 19 questions 14% TOTAL 130 Questions 100% HOW TO PREPARE FOR THE SERIES 65 EXAM? For most candidates the combination of reading the textbook, watching the videos, and using the exam prep software is enough to successfully complete the exam. It is recommended that the individual spend at least 40 hours preparing for the exam by reading the textbook, underlining key points, watching the video class, and by taking as many practice questions as possible. We recommend that a student schedule his or her exam no more than one week after completing the Series 65 exam prep. Test-Taking Tips □□Read the full question before answering. □□Identify what the question is asking. □□Identify key words and phrases. □□Watch out for hedge clauses, for example, except and not. □□Eliminate wrong roman numeral answers. □□Identify synonymous terms. □□Be wary of changing answers. WHY DO I NEED TO TAKE THE SERIES 65 EXAM? In order to conduct fee-based securities business, most states require that an agent successfully complete the Series 65 exam. Passing the Series 65 exam will allow an agent to receive asset-based management and other advisory fees. The Series 65 is often taken in addition to obtaining a Series 6, 7, or 62 registration, which allow an agent to receive transaction-based compensation. WHAT SCORE IS NEEDED TO PASS THE EXAM? A score of 72% or higher is needed to pass the Series 65 exam. ARE THERE ANY PREREQUISITES FOR THE SERIES 65 EXAM? A candidate is not required to have any other professional qualifications prior to taking the Series 65 exam. HOW DO I SCHEDULE AN EXAM? Ask your firm’s principal to schedule the exam for you, or for a list of test centers in your area. You may be self-sponsored to take the exam. You must fill out and submit form U10 prior to making an appointment. The Series 65 exam may be taken any day that the exam center is open. WHAT MUST I TAKE TO THE EXAM CENTER? A picture ID is required. All other materials will be provided, including a calculator and scratch paper. HOW SOON WILL I RECEIVE THE RESULTS OF THE EXAM? The exam will be graded as soon as you answer your final question and hit the Submit for Grading button. It will take only a few minutes to get your results. Your grade will appear on the computer screen and you will be given a paper copy from the exam center. If you do not pass the test, you will need to wait 30 days before taking it again. If you do not pass on the second try, you’ll need to wait another 30 days. After that, you are required to wait 6 months to take the test again. About the Series 65 Exam xxiii About This Book The writers and instructors at The Securities Institute have developed the Series 65 textbook, exam prep software, and videos to ensure that you have the knowledge required to pass the test, and to make sure that you are confident in the application of that knowledge during the exam. The writers and instructors at The Securities Institute are subject matter experts as well as Series 65 test experts. We understand how the test is written and our proven test-taking techniques can dramatically improve your results. Each chapter includes notes, tips, examples, and case studies with key information, hints for taking the exam, and additional insight into the topics. Each chapter ends with a practice test, to ensure you have mastered the concepts before moving on to the next topic. About the Test Bank This book is accompanied by a test bank of more than 350 questions to further reinforce the concepts and information presented here. The access card in the back of this book includes the URL and PIN code you can use to access the test bank. This test bank provides a small sample of the questions and features that are contained in the full version of the Series 65 exam prep software. If you have not purchased the full version of the exam prep software with this book, we highly recommend it to ensure that you have mastered the knowledge required for your Series 65 exam. To purchase the exam prep software for this exam, visit The Securities Institute of America online at www.SecuritiesCE.com or call . About The Securities Institute of America The Securities Institute of America, Inc. helps thousands of securities and insurance professionals build successful careers in the financial services industry every year. Our securities training options include: • On-site training classes • Private tutoring • Classroom training • Interactive online video training classes • State-of-the-art exam-preparation software • Printed textbooks • Real-time tracking and reporting for managers and training directors You can choose a securities training solution that matches your skill level, learning style, and schedule. Regardless of the format you choose, you can be sure that our securities training courses are relevant, tested, and designed to help you succeed. It is the experience of our instructors and the quality of our materials that make our courses requested by name at some of the largest financial services firms in the world. To contact The Securities Institute of America, visit us on the Web at www.SecuritiesCE.com or call . CHAPTER 1 Equity Securities INTRODUCTION This first chapter will build the foundation upon which the rest of this text is built. A thorough understanding of equity securities will be necessary in order to successfully complete the Series 65 exam. Equity securities are divided into two types: common and preferred stock. We will examine the features of common stock and preferred stock, as well as the benefits and risks associated with their ownership, but first we must define exactly what meets the definition of a security. WHAT IS A SECURITY? A security is any investment product that can be exchanged for value and involves risk. In order for an investment to be considered a security, it must be readily transferable between two parties and the owner must be subject to the loss of some, or all, of the invested principal. If the product is not transferable or does not contain risk, it is not a security. Types of Securities Types of Nonsecurities Common stock Whole life insurance Preferred stock Term life insurance Bonds IRAs Mutual funds Retirement plans (Continued) 2 WILEY SERIES 65 Exam Review 2016 Types of Securities Types of Nonsecurities Variable annuities Fixed annuities Variable life insurance Prospectus Options Confirmations Rights Warrants ETFs/ETNs Real estate investment trusts CMOs EQUITY = STOCK The term equity is synonymous with the term stock. Throughout your preparation for this exam and on the exam itself, you will find many terms that are used interchangeably. Equity or stock creates an ownership relationship with the issuing company. Once an investor has purchased stock in a corporation, they become an owner of that corporation. The corporation sells off pieces of itself to investors in the form of shares in an effort to raise working capital. Equity is perpetual, meaning there is no maturity date for the shares and the investor may own the shares until they decide to sell them. Most corporations use the sale of equity as their main source of business capital. COMMON STOCK There are thousands of companies whose stock trades publicly and who have used the sale of equity as a source of raising business capital. All publicly traded companies must issue common stock before they may issue any other type of equity security. There are two types of equity securities: common stock and preferred stock. While all publicly traded companies must have sold or issued common stock, not all companies may want to issue or sell preferred stock. Let’s take a look at the creation of a company and how common stock is created. CORPORATE TIME LINE The following is a representation of the steps that corporations must take in order to sell their common stock to the public, as well as what may happen to that stock once it has been sold to the public. CHAPTER 1 Equity Securities 3 AUTHORIZED STOCK Authorized stock is the maximum number of shares that a company may sell to the investing public in an effort to raise cash to meet the organization’s goals. The number of authorized shares is arbitrarily determined and is set at the time of incorporation. A corporation may sell all or part of its authorized stock. If the corporation wants to sell more shares than it’s authorized to sell, the shareholders must approve an increase in the number of authorized shares. ISSUED STOCK Issued stock is stock that has been authorized for sale and that has actually been sold to the investing public. The total number of authorized shares typically exceeds the total number of issued shares so that the corporation may sell additional shares in the future to meet its needs. Once shares have been sold to the investing public, they will always be counted as issued shares, regardless of their ownership or subsequent repurchase by the corporation. It’s important to note that the total number of issued shares may never exceed the total number of authorized shares. Additional authorized shares may be issued in the future for any of the following reasons: • Pay a stock dividend • Expand current operations • Exchange common shares for convertible preferred or convertible bonds • To satisfy obligations under employee stock options or purchase plans OUTSTANDING STOCK Outstanding stock is stock that has been sold or issued to the investing public and that actually remains in the hands of the investing public. EXAMPLE: XYZ corporation has 10,000,000 shares authorized and has sold 5,000,000 shares to the public during its initial public offering. In this case, there would be 5,000,000 shares of stock issued and 5,000,000 shares outstanding. TREASURY STOCK Treasury stock is stock that has been sold to the investing public, which has subsequently been repurchased by the corporation. The corporation may elect 4 WILEY SERIES 65 Exam Review 2016 to reissue the shares or it may retire the shares that it holds in treasury stock. Treasury stock does not receive dividends, nor does it vote. A corporation may elect to repurchase its own shares for any of the following reasons: • To maintain control of the company • To increase earnings per share • To fund employee stock purchase plans • To use shares to pay for a merger or acquisition To determine the amount of treasury stock, use the following formula: Issued stock – outstanding stock = treasury stock EXAMPLE If, in the case of XYZ, the company decides to repurchase 3,000,000 of its own shares then XYZ would have 5,000,000 shares issued, 2,000,000 shares, and 3,000,000 shares of treasury stock. It’s important to note that once the shares have been issued, they will always be counted as issued shares. The only thing that changes is the number of outstanding shares and the number of treasury shares. VALUES OF COMMON STOCK A common stock’s market value is determined by supply and demand and may or may not have any real relationship to what the shares are actually worth. The market value of common stock is affected by the current and future expectations for the company. BOOK VALUE A corporation’s book value is the theoretical liquidation value of the company. The book value is found by taking all of the company’s tangible assets and subtracting all of its liabilities. This will give you the total book value. To determine the book values per share, divide the total book value by the total number of outstanding common shares. CHAPTER 1 Equity Securities 5 PAR VALUE Par value, in a discussion regarding common stock, is only important if you are an accountant looking at the balance sheet. An accountant uses the par value as a way to credit the money received by the corporation from the initial sale of the stock to the balance sheet. For investors, it has no relationship to any measure of value, which may otherwise be employed. RIGHTS OF COMMON STOCKHOLDERS As an owner of common stock, investors are owners of the corporation. As such, investors have certain rights that are granted to all common stock holders. PREEMPTIVE RIGHTS As a stockholder, an investor has the right to maintain their percentage interest in the company. This is known as a preemptive right. Should the company wish to sell additional shares to raise new capital, they must first offer the new shares to existing shareholders. If the existing shareholders decide not to purchase the new shares, then the shares may be offered to the general public. When a corporation decides to conduct a rights offering, the board of directors must approve the issuance of the additional shares. If the number of shares that are to be issued under the rights offering would cause the total number of outstanding shares to exceed the total number of authorized shares, then shareholder approval will be required. Existing shareholders will have to approve an increase in the number of authorized shares before the rights offering can proceed. TESTFOCUS! Number of Existing Shares Number of New Shares Total Shares After Offering 100,000 100,000 200,000 10,000 10% ownership 10,000 10% of offering 20,000 10% ownership 6 WILEY SERIES 65 Exam Review 2016 In this example, the company has 100,000 shares of stock outstanding and an investor has purchased 10,000 of those original shares. As a result, they own 10% of the corporation. The company wishing to sell 100,000 new shares to raise new capital must first offer 10% of the new shares to the current investor (10,000 shares) before the shares may be offered to the general public. So if the investor decides to purchase the additional shares, as is the case in the example, the investor will have maintained his or her 10% interest in the company. A shareholder’s preemptive right is ensured through a rights offering. The existing shareholders will have the right to purchase the new shares at a discount to the current market value for up to 45 days. This is known as the subscription price. Once the subscription price is set, it remains constant for the 45 days, while the price of the stock is moving up and down in the market place. There are three possible outcomes for a right. They are: 1. Exercised: The investor decides to purchase the additional shares and sends in the money, along with the rights to receive the additional shares. 2. Sold: The rights have value and if the investor does not want to purchase the additional shares, they may be sold to another investor who would like to purchase the shares. 3. Expire: The rights will expire when no one wants to purchase the stock. This will only occur when the market price of the share has fallen below the subscription price of the right and the 45 days has elapsed. CHARACTERISTICS OF A RIGHTS OFFERING Once a rights offering has been declared, the company’s common stock will trade with the rights attached. The stock in this situation is said to be trading cum rights. The company’s stock, which is the subject of the rights offering, will trade cum rights between the declaration date and the ex date. After the ex date, the stock will trade without the rights attached or will trade ex rights. The value of the common stock will be adjusted down by the value of the right on the ex-rights date. During a rights offering, each share will be issued one right. The subscription price and the number of rights required to purchase one additional share will be detailed in the terms of the offering on the rights certificate. During a rights offering, the issuer will retain an investment bank CHAPTER 1 Equity Securities 7 to act as a standby underwriter and the investment bank will stand by, ready to purchase any shares that are not purchased by the rights holders. DETERMINING THE VALUE OF A RIGHT CUM RIGHTS In order to determine the value of one right before the ex-rights date, you must use the cum-rights formula. Subtract the subscription price of the right from the market price of the stock. Once the discount (if any) has been determined, divide the discount by the number of rights required to purchase one share plus one. This will determine the value of one right. EXAMPLE XYZ has 10,000,000 shares of common stock outstanding and is issuing 5,000,000 additional common shares through a rights offering. XYZ is trading in the marketplace at $51 per share and the rights have a subscription price of $48 per share. Keep in mind that the stock price reflects the value of the right that is still attached to the stock. The value of a right is determined as follows: Stock price − Subscription price The number of rights required to purchase one share + 1 $ 51 − $48 $ 3 $3/3 rights = $1 Because each one of the 10,000,000 shares is entitled to receive one right and the company is offering 5,000,000 additional shares, it will require $48, plus two rights, to subscribe to one additional share. The rights agent will handle the name changes when the rights are purchased and sold in the market place. DETERMINING THE VALUE OF A RIGHT EX RIGHTS In order to determine the value of one right after the ex-rights date, subtract the subscription price of the right from the market price of the stock. Once the discount (if any) has been determined, divide the discount by the number of rights required to purchase one share. This will determine the value 8 WILEY SERIES 65 Exam Review 2016