What is Convertible Preferred 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 yieldDividend YieldDividend yield ratio is the ratio of a company’s current dividend to its current share price.  It represents the potential return on investment for a given stock.read more of 5%, i.e. $25 per share along with a 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 (the conversion date).

Applying the 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.

Case #1

Now let’s assume on June 1, 2008, the stock price was trading at @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. It 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 exercise his conversion right as he can get the same stock at ten 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.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Convertible Preferred Stock (wallstreetmojo.com)

Advantages

  • Convertible preferred stock enjoys preferential right over equity shares regarding the dividend payment and capital repayment in case of winding up.If the stock prices appreciate, investors can choose to convert their preferred stock to common stock. They can realize again in the form of capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more from company success while still protected from failure. On the other hand, if the company’s poor performance, it can choose not to exercise the conversion right and keep its 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 shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more.Before conversion, the issuance of preference shares do not lead to dilution of control, i.e., they do not carry voting rights nor interfere in company decisions.The relatively low dividend yield on convertible stock may provide convenience to rapidly growing firms facing heavy capital expendituresCapital ExpendituresCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more. 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, further increasing the risk of financial distress.Issuance of Convertible sharesConvertible SharesConvertible securities are securities or investments (preferred stocks or convertible bonds) that can be easily converted into a different form, such as shares of an entity’s common stock, and are typically issued by entities to raise money. In most cases, the entity has complete control over when the conversion occurs.read morecan 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, 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 the conversion feature is exercised, the preference shareholder will be treated as another equity shareholder who enjoys no priority in either dividend or asset distribution.The exercise of convertible options increases the number of outstanding shares and creates dilution of control from the perspective 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.Like bonds, most convertible shares are rated by large organizations such as S&P, Moody, and Fitch.Investors must consider whether a higher yield will compensate them with higher risks like equity security when exercising the convertible option.

This has been a guide to What is Convertible Preferred Stock & its Definition. Here we discuss the convertible preferred stock example and its advantages and disadvantages. You can learn more about it from the following articles –

  • Convertible DebtConvertible SecuritiesConvertible ArbitrageAccounting for Convertible Bonds