Equity Investments. 14 question(s) in this unit's pool
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Question 1Exam level
An investor holds 1,000 shares of a company with 5 board director seats up for election. Under cumulative voting, the maximum number of votes the investor can cast for a single director candidate is closest to:
How sure are you?
Correct: A. Under cumulative voting, a shareholder receives votes equal to shares held multiplied by the number of director seats being contested. The shareholder may concentrate all votes on one candidate. 1,000 shares × 5 seats = 5,000 total votes, all of which may be cast for one director. Under statutory (straight) voting, the investor would cast a maximum of 1,000 votes per seat. Cumulative voting is designed to give minority shareholders greater board representation power. The exam tests this distinction frequently.
B. Choosing 200 might tempt you if you mistakenly divide the total votes by the number of seats, thinking each seat gets an equal share of your votes, but under cumulative voting, you can concentrate all your votes on a single candidate, making 200 far too conservative.
C. Choosing 5 might tempt you if you mistakenly think each share only gets one vote for each seat, but cumulative voting allows you to concentrate all your votes on a single candidate, so you multiply your shares by the number of seats, not limit yourself to one vote per seat.
Unit: overview-of-equity-securities
Question 2Exam level
A company's preferred stock pays a cumulative dividend of $3.00 per share annually. The company skipped dividends in Year 1 and Year 2 due to financial difficulty. In Year 3, the company earned sufficient profits to resume dividends. Before paying any common stock dividend in Year 3, the minimum total preferred dividend per share that must be paid is closest to:
How sure are you?
Correct: B. Cumulative preferred stock requires that all dividends in arrears (unpaid dividends from prior periods) must be paid before any common dividend can be distributed. Two years of arrears ($3.00 × 2 = $6.00) plus the current year's dividend ($3.00) = $9.00 total. Non-cumulative preferred stock does NOT accumulate arrears. Skipped dividends are gone permanently. This distinction is the single most tested concept in preferred stock on the CFA exam.
A. Choosing $6.00 might seem right if you only considered the dividends in arrears from Year 1 and Year 2, but it ignores the current year's dividend requirement for cumulative preferred stock, which means you must also add the Year 3 dividend of $3.00, making the total $9.00.
C. Choosing $0 because you might think preferred dividends are discretionary overlooks the mandatory nature of cumulative preferred dividends, which require all missed dividends plus the current year's dividend to be paid before any common dividends, totaling $9.00 in this case.
Unit: overview-of-equity-securities
Question 3Exam level
Which of the following best describes a sponsored Level I American Depositary Receipt (ADR)?
How sure are you?
Correct: B. Sponsored Level I ADRs are the most common. The foreign issuer cooperates with the depositary bank but is exempt from full SEC registration. They need only file Form F-6 and provide materials translated into English. They trade OTC (Pink Sheets/OTC Bulletin Board), NOT on major exchanges. Level II ADRs trade on major exchanges (NYSE, NASDAQ, AMEX) and require full Form 20-F filing. Level III ADRs additionally allow new capital raising in the US public markets. Unsponsored ADRs are created by depositary banks WITHOUT the foreign company's involvement and always trade OTC.
A. You might be tempted by choice A if you confuse sponsored with unsponsored ADRs, but choice A describes an unsponsored ADR where the foreign company does not cooperate, whereas in a sponsored Level I ADR, the foreign company actively cooperates with the US depositary bank.
C. You might be tempted by choice C if you associate SEC registration with the ability to raise new capital, but remember that sponsored Level I ADRs only meet minimal SEC reporting requirements and do not allow for new capital raising in the US primary market like Level III ADRs do.
Unit: overview-of-equity-securities
Question 4Exam level
Participating preferred stock is MOST likely to benefit shareholders when:
How sure are you?
Correct: B. Participating preferred stock allows holders to receive additional dividends beyond the stated rate if the company's profits exceed a specified threshold. Effectively 'participating' in the company's success alongside common shareholders. This feature benefits holders only when the company is highly profitable and declares excess dividends. The other scenarios describe benefits of cumulative preferred (A), liquidation preference (B), and falling interest rates which benefit non-callable fixed-rate preferred (D).
A. You might be tempted by choice A because it aligns with the typical liquidation preference of preferred stock, but participating preferred stock specifically benefits from additional dividends when the company is profitable, not from recovering par value during liquidation.
C. You might be tempted by choice C because falling interest rates typically make fixed-income securities more attractive, but participating preferred stock benefits from company profitability, not interest rate movements, making this choice irrelevant to the question.
Unit: overview-of-equity-securities
Question 5Exam level
Putable preferred stock is MOST advantageous to investors when:
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Correct: A. Putable preferred stock gives the holder the right to sell shares back to the issuer at a predetermined price. This right is most valuable when interest rates rise, because rising rates reduce the market value of fixed-income-like instruments (including fixed-rate preferred stock). The put option allows investors to exit at the put price rather than selling at a depressed market price. Callable preferred benefits the ISSUER when rates fall (they can refinance at lower cost). Convertible preferred benefits investors when the common stock price rises.
B. You might be tempted by the idea that a premium call is beneficial because it offers extra money, but remember that a put option is most valuable when market conditions, like rising interest rates, make the stock less valuable; a premium call by the company does not leverage this put feature effectively.
C. You might be tempted by the conversion feature of preferred stock, thinking it offers flexibility, but convertible preferred stock is designed to benefit from rising common stock prices, not to protect against rising interest rates like a put option does.
Unit: overview-of-equity-securities
Question 6Exam level
Global Depositary Receipts (GDRs) most likely differ from American Depositary Receipts (ADRs) primarily because GDRs:
How sure are you?
Correct: B. GDRs are negotiable certificates representing ownership of shares in a foreign company, similar to ADRs, but they can be listed and traded on multiple exchanges in multiple countries simultaneously (e.g., London Stock Exchange, Luxembourg Stock Exchange, Dubai Financial Market). ADRs are specifically structured for US markets and denominated in USD. GDRs are typically denominated in USD or Euros and are commonly used by companies seeking capital from investors across multiple jurisdictions without listing in each country's domestic market.
A. You might think GDRs bypass the need for a depositary bank, but both GDRs and ADRs require a depositary bank to act as an intermediary, making choice A incorrect.
C. You might think that GDRs require full compliance with each country's reporting rules because they are listed in multiple countries, but this overlooks the simplified reporting framework GDRs actually use, which contrasts with the broader flexibility of being listed on multiple exchanges as the correct answer indicates.
Unit: overview-of-equity-securities
Question 7Exam level
Which of the following is a characteristic that most likely distinguishes common stockholders from preferred stockholders?
How sure are you?
Correct: B. Voting rights for corporate matters (board elections, major transactions, charter amendments) are the defining right of common stockholders. Preferred stockholders typically have NO voting rights in routine corporate governance matters (though they may gain voting rights if dividends are in arrears). Common stockholders have the LOWEST priority in liquidation (below all creditors and preferred shareholders). Preferred dividends are typically fixed; common dividends vary. Both common and preferred shareholders have limited liability. Limited to their investment, not par value.
A. You might be tempted to choose A because fixed dividend rates sound like a clear distinction, but in reality, it is preferred stockholders who receive dividends at a fixed rate, not common stockholders, who have variable dividends and the key distinction of voting rights.
C. Both common and preferred stockholders carry limited liability, capped at what they invested, not at the shares' par value, and preferred stockholders do not carry unlimited liability at all. Limited liability is a feature of the corporate form itself and applies equally to both share classes, so it cannot be the characteristic that tells common and preferred stock apart. Voting rights are what actually separates them.
Unit: overview-of-equity-securities
Question 8Exam level
A company issues callable preferred stock with a call price of $110 per share when prevailing market interest rates are 6%. If interest rates subsequently fall to 4%, the company will MOST likely:
How sure are you?
Correct: A. Callable preferred stock gives the ISSUER the right to redeem shares at the call price. When interest rates fall, the issuer can refinance at lower cost. Exactly analogous to a mortgage holder refinancing when rates drop. The company calls the expensive fixed-rate preferred (e.g., 6% dividend) and issues new preferred at the prevailing lower rate (e.g., 4%). This is why callable preferred is advantageous to issuers but creates reinvestment risk for investors. The call provision caps the price appreciation investors can expect when rates fall.
B. You might be tempted to choose B because it seems like a way to reduce dividend payments, but callable preferred stock does not have a conversion feature into common stock; instead, the call feature allows the company to redeem the shares at a specified price, enabling them to reissue new preferred stock at a lower dividend rate when interest rates fall.
C. You might be tempted to choose C because it involves a similar concept of returning shares to the issuer, but preferred stock typically does not have a put provision that allows shareholders to force the company to buy back shares; instead, callable preferred stock gives the company the option to buy back shares at a specified price, which aligns with the correct answer A.
Unit: overview-of-equity-securities
Question 9Exam level
An unsponsored American Depositary Receipt (ADR) is most likely described as:
How sure are you?
Correct: B. Unsponsored ADRs are created by depositary banks to meet investor demand for foreign shares WITHOUT the foreign company's involvement. The depositary bank purchases the foreign shares and issues ADRs against them. Because the foreign company has no agreement with the depositary bank, disclosure obligations fall to the depositary. These always trade OTC. Sponsored ADRs (Levels I, II, III) involve an agreement between the depositary bank and the foreign company. The key exam distinction: sponsored = company cooperation; unsponsored = bank initiative only.
A. You might be tempted by choice A because it sounds like a typical SEC-registered security, but ADRs that trade on major US exchanges after full SEC registration are actually sponsored ADRs, not unsponsored ones, which do not require the foreign company's registration or consent and trade over-the-counter.
C. Choosing C might seem logical if you think ADRs are a means for foreign companies to raise capital, but ADRs, especially unsponsored ones, do not allow foreign companies to raise new equity capital directly; instead, they represent existing shares of a foreign company traded in the US market without the company's direct involvement or consent.
Unit: overview-of-equity-securities
Question 10Exam level
Which type of preferred stock is most likely similar to a bond in terms of its risk/return profile for investors?
How sure are you?
Correct: B. Preferred stock with none of the equity-upside features (no participation in excess profits, no conversion to common) and with issuer call rights behaves most like a corporate bond: fixed payment, no growth participation, callable when rates fall. The CFA curriculum explicitly notes this bond-like characteristic and tests whether candidates understand that preferred stock sits between debt and common equity in the capital structure. Participating and convertible preferred have equity upside. Cumulative preferred with voting rights has additional protections that differ from bond mechanics.
A. You might be tempted by convertible preferred stock because it offers the potential to convert into common stock, which could seem like a bond-like feature. However, this conversion option introduces equity-like upside potential, which contrasts with the bond-like characteristics of non-cumulative, non-participating, non-convertible, callable preferred stock that lacks such equity upside.
C. You might be tempted by the voting rights and cumulative feature, thinking they offer more security, but these features actually make cumulative preferred stock less bond-like by providing additional protections and potential returns that bonds do not offer.
Unit: overview-of-equity-securities
Question 11Exam level
An investor purchases 500 shares of foreign Company X through a Global Registered Share (GRS) on the London Stock Exchange. The investor later decides to sell on the Tokyo Stock Exchange. Which of the following BEST describes the GRS structure?
How sure are you?
Correct: A. Global Registered Shares (GRS) are the same underlying share issued by the company, registered and tradeable across multiple markets simultaneously without needing a depositary bank intermediary. Unlike ADRs and GDRs (which are depositary receipts. Derivative instruments backed by underlying shares held by a bank), GRS are the actual shares of the company, denominated in local currencies and traded natively on each exchange. GRS eliminate the conversion process required with depositary receipts. Daimler (now Mercedes-Benz Group) was one of the first companies to issue GRS.
B. You might be tempted by choice B because it sounds similar to how depositary receipts work, but GRS are not certificates held by a bank they are the actual shares of the company, directly tradeable across exchanges.
C. You might be thinking that cross-border trading requires separate registration and settlement, which is true for some securities, but GRS are designed to be fungible and tradeable across exchanges without such requirements, making choice C incorrect as it violates the fundamental concept of GRS fungibility and seamless cross-border trading.
Unit: overview-of-equity-securities
Question 12Exam level
When analyzing equity securities, which of the following is MOST accurate regarding the residual claim right of common stockholders?
How sure are you?
Correct: A. The 'residual claim' means common shareholders receive whatever is left after all other claims are satisfied. Secured creditors, unsecured creditors, then preferred shareholders, and finally common shareholders. In practice, common shareholders often receive nothing in bankruptcy liquidation. The term 'residual' reflects this last-in-line status. This is why common equity is considered the riskiest component of the capital structure, and why common shareholders demand the highest expected returns.
B. You might be tempted by choice B because it sounds fair that common and preferred stockholders share equally after debt repayment, but this overlooks the hierarchical structure of claims where preferred stockholders have priority over common stockholders, making it incorrect.
C. You might be tempted by the idea of guaranteed returns, but common stockholders do not have a guaranteed minimum dividend; the residual claim means they only receive what is left after all other claims are satisfied, which could be nothing.
Unit: overview-of-equity-securities
Question 13Above the exam
An investor is comparing an investment in the common shares of a private company to an investment in the American Depositary Receipts (ADRs) of a foreign public company trading on a US exchange. Combining the liquidity and information characteristics of private versus public equity with the specific mechanics of an ADR, the investor should most likely conclude that:
How sure are you?
Correct: B. An ADR is a negotiable certificate, issued by a depositary bank, representing shares of a foreign company, that trades on a US exchange just like a domestic stock, giving US investors convenient, liquid, exchange-traded access, and the ADR issuer is subject to applicable US public-company disclosure requirements. Private company shares, by contrast, have no organized public market (illiquid, often hard to value or exit) and face far lighter disclosure requirements than a public, exchange-listed security. Combining these liquidity and disclosure characteristics correctly distinguishes the two.
A. Private and public equity differ dramatically in both liquidity (an organized public market versus none) and disclosure (extensive public-company requirements versus minimal), which is exactly why the equity-securities LOS distinguishes them; 'identical characteristics' ignores both dimensions entirely.
C. There is no general rule that private companies are automatically undervalued relative to public ones; valuation depends on the specific business, and if anything, the ILLIQUIDITY of private shares typically commands a valuation DISCOUNT, not a premium, all else equal.
Unit: overview-of-equity-securities
Question 14Above the exam
A company has issued both non-convertible preferred stock and common stock. During a year of financial distress, the company suspends its common dividend but the preferred stock is cumulative. Combining the definition of cumulative preferred stock with the priority of claims across the company's capital structure, an investor should most likely conclude that:
How sure are you?
Correct: A. Cumulative preferred stock means any skipped dividends accrue as an unpaid obligation (dividends in arrears) that must be paid in full before the company can resume paying COMMON dividends; it does not mean the dividend is guaranteed to be paid in the year it is skipped. Preferred stock, cumulative or not, still generally carries no voting rights in ordinary circumstances and ranks below all debt holders (senior and subordinated) in a liquidation, even though it ranks above common equity.
B. Cumulative status affects the treatment of UNPAID DIVIDENDS (they accrue as a claim ahead of common dividends), not voting control; preferred shareholders typically remain without general voting rights even after dividends are skipped, absent a specific contractual provision granting contingent voting rights (which is not implied by 'cumulative' alone).
C. Cumulative preferred stock does not guarantee the dividend WILL be paid in a distress year; the company can still suspend it. 'Cumulative' only means the suspended amount accrues and must eventually be paid (before common dividends resume), not that payment is forced in the year it would otherwise be skipped.