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Difficulty: HardEquity Securities and Characteristics

An investor holds 500 shares of a corporation's 6% cumulative convertible preferred stock (100parvalue),initiallyconvertibleintocommonstockataconversionpriceof100 par value), initially convertible into common stock at a conversion price of 20 per share. The preferred stock agreement features standard anti-dilution covenant protections. After the corporation executes a 2-for-1 common stock split, the issuer announces a redemption call for all preferred shares at 105pershare.Withthecommonstockcurrentlytradingat105 per share. With the common stock currently trading at 12 per share in the secondary market, which course of action provides the investor with the highest total dollar value?

  1. Converting the preferred stock into common shares based on the anti-dilution adjusted conversion ratioAnswer
  2. B
    Tendering the preferred shares to the issuer to receive the redemption call price
  3. C
    Converting the preferred stock using the original unadjusted conversion price of $20 per share
  4. D
    Rejecting the redemption notice to maintain dividend priority over common shareholders

Answer

Converting the preferred stock into common shares based on the anti-dilution adjusted conversion ratio produces the highest total value ($60,000).
The preferred stock's anti-dilution covenant adjusts the conversion price downward from 20to20 to 10 following the 2-for-1 stock split, increasing the conversion ratio from 5 to 10 common shares per preferred share. Converting 500 preferred shares yields 5,000 common shares worth 60,000at60,000 at 12 per share in the open market. This exceeds the call redemption payout of 52,500(500shares∗52,500 (500 shares * 105).

Step-by-Step Solution

1
Calculate the initial conversion ratio per preferred share.
Initial Conversion Ratio = 100parvalue/100 par value / 20 conversion price = 5 common shares per preferred share.
The conversion ratio equals the preferred stock par value divided by the stated conversion price.
2
Adjust the conversion price and conversion ratio for the 2-for-1 common stock split.
New Conversion Price = 20/2=20 / 2 = 10 per share; New Conversion Ratio = 100/100 / 10 = 10 common shares per preferred share.
Anti-dilution covenants require a proportional reduction in conversion price and an increase in conversion ratio following stock splits to protect preferred holders.
3
Compare the total market value of conversion against the issuer's call redemption payout.
Conversion Value = 500 preferred shares * 10 common shares * 12=12 = 60,000. Call Redemption Value = 500 preferred shares * 105=105 = 52,500.
Comparing total proceeds demonstrates that converting into common stock yields $7,500 more value than accepting the issuer's redemption call.

Key Concept

Anti-Dilution Adjustments and Forced Conversions of Convertible Preferred Stock
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Topics

Equity Securities and Characteristics

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