The Contrell Company is planning to finance an expansion with convertible prefer
ID: 2601667 • Letter: T
Question
The Contrell Company is planning to finance an expansion with convertible preferred stock. Each share will pay a dividend of $2.10 per share. The price of the company's common stock is currently $42. The conversion ratio will be 1.0, i.e., each share of convertible preferred can be converted into one share of common. The convertible's par value (and also the issue price) will be equal to the conversion price. The conversion price will be a premium over the current market price of the common stock.
a) Calculate the conversion price if it is set at a 10% premium.
b) Calculate the conversion price if it is set at a 30% premium
c) If the company expects its growth rate to be high, would it be better to use a premium of 10% or a 30%? Why?
d) If the company expects its growth rate to be low, would it be better to use a premium of 10% or a 30%? Why?
e) Should the convertible preferred stock include a call provision? Why or why not?
Explanation / Answer
a)
Premium
10%
current market price
$ 42.00
Conversion Price
$ 46.20
((1+10%)*42)
b)
Premium
30%
current market price
$ 42.00
Conversion Price
$ 54.60
((1+30%)*42)
c)
If the company expects the growth rate to be high enough then it would be better to use the conversion premium of 10%. The firm would want to pay less and fewer dividends to fund growth therefore it would want the investors to convert the preferred stock into shares so that the firm don’t need to pay dividends furthermore. Hence firm should keep the premium to low value so as to motivate the conversion. Hence 10 % conversion premium is apt.
d)
If the company expects the growth rate to be low enough then it would be better to use the conversion premium of 30%. The firm would want to pay dividends as there are enough funds available besides funds required to support low growth therefore it would not want the investors to convert the preferred stock into shares so that the firm need to pay dividends in future. Hence firm should keep the premium to high value so as to not motivate the conversion. Hence 30% conversion premium is apt.
e)
Looking from the investor's perspective, Convertible preferred stock should not include a call provision that is because when the stock price rises the preferred stock can be called back at a stated premium over the par value and the investors do not share in the growth of the stock and the dividends that are to be paid to them. Whereas Looking from the issuer's perspective, Convertible preferred stock should include a call provision because the issuer can refund using a lower dividend rate as compared to higher previous dividend rate therefore making a savings in its dividends distributed.
a)
Premium
10%
current market price
$ 42.00
Conversion Price
$ 46.20
((1+10%)*42)
b)
Premium
30%
current market price
$ 42.00
Conversion Price
$ 54.60
((1+30%)*42)
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