What is Convertible Preferred Stock?
Convertible preferred stocks are a special class of stocks issued by the company which gives the right to the investor to convert its preferred stock holding into fixed numbers of shares of company common stock after the predetermined time span. Convertibles preferred are hybrid instruments with bond and equity-like features wherein, it is equivalent to bonds with fixed dividend payment plus as the option to acquire common stock.
Example
An investor bought 100 shares of convertible preferred stock in ABC Company @ 500 per share on June 1, 2007. So, the initial investment made by an investor is $50000 (100 shares * $500). It offers a fixed dividend yield of 5%, i.e. $25 per share along with special conversion right wherein 1 share of preferred stock can be converted into 50 shares of common stock (known as conversion ratio), i.e. if an investor opts for conversion, he will be entitled to 5000 common shares (100 preferred stock * 50 common shares). This right can only be applied after June 1, 2008 (known as conversion date).
Applying below formulae can give the total cost per common share after conversion is applied:
In this case, it’s $10 (500/50) which is termed as the conversion price.
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Case #1
Now let’s assume on June 1, 2008, the stock price is trading @7 per share in the market. If the investor decides to convert his holding into common stock, the total value of his investment will be $35000 (5000 common shares * $7) on that day. This will fetch him a total loss of $15000 after considering his initial investment of $50000.
Case #2
Now let’s assume that the stock price increased to $30. He would definitely exercise his conversion right as he can get the same stock at 10 as compared to the market price of $30. The difference between $30 and $10 is called the conversion premium. Post conversion, the total value of his investment will increase to $150000 from $50000, giving him a net realizable gain of $100000.
Advantages
- Convertible preferred stock enjoys preferential right over equity shares with regard to the dividend payment and repayment of capital in case of winding up.
- They can realize a gain in the form of capital appreciation from company success while still protected from company failure. If the stock prices appreciate, investors can choose to convert their preferred stock to common stock. On the other hand, if the company performance is poor, they can choose not to exercise the conversion right and keep their convertible stock.
- In the event of bankruptcy, if the conversion feature is not exercised, they are given priority in dividend payment and asset distribution of remaining assets before equity shareholders.
- Prior to conversion issuance of preference shares do not lead to dilution of control, i.e. they do not carry voting rights nor interferes in company decision.
- The relatively low dividend yield on convertible stock may provide convenience to rapidly growing firms facing heavy capital expenditures. Corporates may be willing to provide a conversion option to reduce immediate cash requirements for dividend payments. Without this option, investors might demand an extremely high dividend to compensate for the probability of default which will further increase the risk of financial distress.
- Issuance of Convertible shares can help the company to raise capital on better terms and conditions as compared to traditional equity and bond financing, especially if the company has a poor credit rating and borrowing from the market will involve a huge cost in the form of high-interest rates or if company stock is already trading at a lower value.
Disadvantages
- The dividend yield on Preferred stock is much lower than other classes of preferred stock due to additional features provided to them, which is conversion right.
- Convertible preferred stock bear higher risks in the event of default as they will be paid only after repayment of principal and interest to bondholders, i.e. they will be par to other equity shareholders.
- When conversion feature is exercised, preference shareholder will be treated as other equity shareholder and enjoys no priority in either in dividend and asset distribution.
- Exercise of convertible options leads to an increase in the number of outstanding shares and creates dilution of control from the perceptive of equity shareholders. Therefore, each shareholder is entitled to a smaller proportion of firm assets and profits. This problem never arises with traded options. If an investor buys an exchange-traded option and subsequently exercises it, there is no effect on the number of shares outstanding.
Key Points to Remember
- Interest rates affect the pricing of Preference shares. Higher rates make them unattractive, whereas low interest makes them attractive.
- Just like bonds most convertible shares are rated by large rating organizations such as S&P, Moody and Fitch.
- When exercising the convertible option, investors must consider whether higher yield will compensate them with higher risk like equity security.
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