91Ó°ÊÓ

In the summer of 2008 , the Hadaway Company was planning to finance an expansion with a convertible security. They considered a convertible debenture but feared the burden of fixed interest charges if the common stock did not rise enough to make conversion attractive. They decided on an issue of convertible preferred stock, which would pay a dividend of \(\$ 1.05\) per share. The common stock was selling for \(\$ 21\) a share at the time. Management projected earnings for 2008 at \(\$ 1.50\) a share and expected a future growth rate of \(10 \%\) a year in 2009 and beyond. The investment bankers and management agreed that the common stock would continue to sell at 14 times earnings, the current price/earnings ratio. a. What conversion price should the issuer set? The conversion rate will be \(1.0 ;\) that is, each share of convertible preferred can be converted into 1 share of common. Therefore, the convertible's par value (as well as the issue price) will be equal to the conversion price, which, in turn, will be determined as a percentage over the current market price of the common. Your answer will be a guess, but it should be a reasonable one. b. Should the preferred stock include a call provision? Why or why not?

Step by step solution

01

Understand the Terms

The conversion price refers to the price at which the preferred stock can be exchanged for common stock. The conversion rate is 1:1, meaning one share of preferred stock can convert into one share of common stock.

02

Determine Projected Price for Common Stock

The price/earnings ratio (P/E ratio) is to remain constant at 14. With earnings projected at $1.50 in 2008, we calculate the price of common stock as follows: \[ Price = 14 \times 1.50 = 21 \, \text{(this is in fact given already, so it's consistent)} \] For 2009 and beyond, use the growth rate to estimate the earnings for next year: \[ Earnings_{2009} = 1.50 \times (1 + 0.10) = 1.65 \] Now calculate the projected stock price: \[ Projected \, Price = 14 \times 1.65 = 23.10 \]

03

Determine Conversion Price with Profitable Expectation

Since the current price is $21 and is projected to increase, the company would want the conversion price to be beneficial for the company while still attractive for investors. Set the conversion price somewhat above the current price to account for potential appreciation. Let's assume a 15% premium:\[ Conversion \, Price = 21 \times 1.15 = 24.15 \]

04

Evaluate Call Provision

A call provision allows the issuer to repurchase the stock at a specific price before the maturity date. Including it could incentivize conversion when the market price is close to the conversion price, benefiting the issuer if rates change or they wish to refinance. Including a call provision makes strategic sense to protect the company if the stock price surges.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Convertible Preferred Stock

Convertible preferred stock is a hybrid financial instrument that bridges the gap between equity and debt. It pays regular dividends like a traditional preferred stock, but it also allows investors to convert their shares into a predetermined number of common stock shares. This conversion option is what makes it appealing to investors.
These stocks are typically issued by companies that anticipate growth but are not entirely sure how their common stock will perform. This makes convertible preferred stocks an attractive option because they give the company flexibility in raising capital. In the Hadaway Company's case, their preference for convertible preferred stocks over debentures was due to the burden of fixed interest charges from debentures.

• Dividends are fixed, like interest on a bond, providing steady income.
• Conversion can be triggered when common stock prices rise, potentially offering capital gains.
• For Hadaway, this offered a less risky way to finance expansion while still potentially attracting new investors.

This creates a balance of benefiting from both growth potential of the company's shares and the income stability of debt instruments.

Price/Earnings Ratio

The price/earnings (P/E) ratio is a vital indicator used to value a company, calculated by dividing the current share price by the earnings per share (EPS).
For Hadaway Company, the P/E ratio was held constant at 14. This ratio reflects the market's expectations of growth and profitability. It is critical to understand that the P/E ratio provides insight into what the market will pay for earnings, and in Hadaway's case, suggested stability and projected growth.
Here's how you can use P/E ratio in evaluating future projections:

• The P/E ratio multiplied by the projected EPS can show expected stock prices.
• In 2008, with EPS at $1.50, the stock price was $21, consistent with a 14 P/E ratio.
• In 2009, EPS was projected to grow to $1.65. This growth translates to a potential share price of $23.10.

The P/E ratio thus becomes a benchmark for assessing if the convertible preferred stock will lead to an attractive conversion option for investors over time as the company's earnings grow.

Call Provision

A call provision grants the company the right to repurchase the securities at pre-set prices before their maturity. This allows the issuer to make strategic financial moves, like refinancing debt or encouraging conversion when market conditions are favorable.
Including a call provision in convertible preferred stock is a strategic choice because:

• It helps the company manage financial flexibility by capitalizing on favorable market conditions.
• If the common stock price approaches the conversion price, the call provision can compel conversion, pushing convertible holders towards conversion to avoid being called.
• For Hadaway Company, incorporating a call provision would safeguard against stock price surges, allowing them to reclaim shares if advantageous. This is crucial for companies expecting significant growth potential.

While adding a call provision can make the investment slightly less attractive due to reduced potential upside, it provides a safety net for issuances, balancing ambition with caution.