Chapter12PreferredStocksandConvertibleSecurities221

Chapter12
PreferredStocksandConvertibleSecurities
.1

Outline

Learning Goals
I.

PreferredStocks
A) PreferredStocksasInvestmentVehicles
1. AdvantagesandDisadvantages
2. SourcesofValue
3. RiskExposure
4. MarketTransactions
B) IssueCharacteristics
1. RightsofPreferredStockholders
2. PreferredStockProvisions
ConceptsinReview

II.

ValuingandInvestinginPreferreds
A) PuttingaValueonPreferreds
1. DividendYield:AKeyMeasureofValue
2. ExpectedReturn
3. BookValue
4. FixedChargeCoverage
5. AgencyRatings
B) InvestmentStrategies
1. LookingforYields
2. TradingonInterestRateSwings
3. SpeculatingonTurnarounds
4. InvestinginConvertiblePreferreds
ConceptsinReview

222Gitman/JoehnkFundamentalsofInvesting,NinthEdition

III. ConvertibleSecurities

Chapter12PreferredStocksandConvertibleSecurities223

A) ConvertiblesasInvestmentOutlets
1. ConvertibleNotesandBonds
2. ConversionPrivilege
3. PercsandLyons
B) SourcesofValue
C) AdvantagesandDisadvantagesofInvestinginConvertibles
D) ExecutingTrades
ConceptsinReview
IV. ValuingandInvestinginConvertibles
A) MeasuringtheValueofaConvertible
1. ConversionValue
a. ConversionPremium
b. PaybackPeriod
2. InvestmentValue
B) AnOverviewofPriceandInvestmentBehavior
C) InvestmentStrategies
1. ConvertiblesasDeferredEquityInvestments
2. AMeasureofExpectedReturn
3. SomeImportantConsiderations
4. ConvertiblesasHighYieldFixedIncomeInvestments

224Gitman/JoehnkFundamentalsofInvesting,NinthEdition

ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
12.1. PenniShowsaPreferenceforPreferreds
12.2. DaveandMarleneConsiderConvertibles
ExcelwithSpreadsheets
TradingOnlinewithOTIS

.2

Key Concepts

1.

Thefundamentalaspectsofpreferredstock,includingsourcesofvalueandrisk.

2.

Basicrightsandclaimsofpreferredstockholders,andsomeofthepopularcharacteristicsoftenfound
withthesesecurities.

3.

Variousmeasuresofinvestmentsuitabilityandseveralpreferredstockinvestmentstrategies.

4.

Generalcharacteristicsofconvertiblesecuritiesandtheconversionprivilege.

5.

Theadvantagesanddisadvantagesofinvestinginconvertibles,includingtheirriskandreturn
characteristics.

6.

Theevaluationofconvertiblesecurityreturnsandtheinvestmenttechniquesthatcanbeusedwith
thesesecurities.

.3

Overview

Somespecialtypesoffixedincomesecuritiespreferredstocksandconvertiblesarediscussedinthis
chapter.Preferredstocksaretreatedfirst,thenconvertibles.
1.

Preferredstocksaredefined.Preferredstocksusuallyhavefixeddividendcharacteristics.Itmightbe
pointedoutthathighcurrentincomeisanadvantageofthisinvestmentvehicle.Sincemostofthe
preferredsharesoutstandingcanbeclassifiedasdebtonissuersfinancialreports(andtax
deductible),mostpreferredstockdividendsdonotqualifyforthenewpreferentialtaxrate.Itmight
beusefultoshowhowtoreadpreferredstockquotationsinthefinancialpagesoftheWSJ.

2.

Issuecharacteristics,investorrightsandclaims,cumulativeprovisionsandcallandsinkingfund
provisionsareconsidered.Cumulativeprovisionsareimportantanddistinctivefeaturesofpreferred
stocksthatshouldbeexplainedindetail.Adjustableratepreferredsandpreferencepreferredsarealso
introducedandbrieflydiscussed.

Chapter12PreferredStocksandConvertibleSecurities225

3.

Thenextsectionoutlinessomewaysofevaluatingpreferredstockforinvestmentpurposes.Atthis
stage,thefollowingconceptsshouldbereviewedcarefully:howtocalculatetheexpectedyieldofa
particularstock,howtoreachaninvestmentdecisionregardingthatstock,andwhatpreferredstock
agencyratingsmeanandwheretoobtainthem.Theinstructorshouldexplaintotheclassthatthe
valueofinvestmentgradepreferredstocksfluctuateswiththemarketrateofinterestanddemonstrate
theinverserelationshipwithaspecificexample.

4.

Convertiblespossessfeaturesofbothfixedincomesecuritiesandequity.Themeaningofequity
kickermaybeexplained.Studentsshouldbemadeawarethateitherbondsorpreferredstockscan
beissuedasconvertiblesecurities.Theadvantagesanddisadvantagesofconvertiblesecuritiesshould
behighlighted.

5.

Thenextsectiondealswithvaluingconvertibles.Itshouldbeemphasizedhowconversionvalueand
conversionpremiumareimportantinaffectingthepriceandreturnperformanceofaconvertible.

6.

Investmentstrategiesrelatedtoconvertiblesarediscussednext.Studentsshouldunderstandthat
convertiblesprovidegoodupsidepotentialthroughtheirequityfeatureanddownsideprotection
throughtheirfixedincomeproperties.Additionally,itshouldalsobeshownthatconvertiblesmaybe
usedforeithercapitalgainsorcurrentincome.Theinstructormightpointoutthatconvertiblesare
popularasinvestmentvehiclesbecausetheyincludethefeaturesofbothstocksandbonds.
Presentationofthepaybackperiodprovidesclarityregardingconversionpremiumdisadvantagesand
comparativecurrentcashflowadvantagesofconvertiblesecurities.

226Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.4

Answers to Concepts in Review

1.

Preferredstocksareequityissuesthatholdapositionseniortocommonstock.Eventhoughpreferred
sharesareaformofequity,theyareconsideredfixedincomesecuritiesbecausetheirlevelofcurrent
incomeisusuallyfixed.Thiscurrentincome(dividendpayments)istypicallypaidquarterlyandhas
priorityovercommondividendpayments;thatis,allpreferreddividendsmustbepaidbeforeany
paymenttocommonstockholdersmaybemade.Also,intheeventofbankruptcy,theclaimsof
preferredstockholdersuptotheparorstatedvalueofthesecuritiesmustbesatisfiedpriortoany
claimsofcommonstockholders.
Somepreferredstockdividendsaretreatedasafinancingcostandaretaxdeductibleatthecorporate
level.Thesepreferredsharesareknownastrustpreferredstocks.Theydonotqualifyforthenew
preferentialtaxrateoffifteenpercentorlessonindividualincometaxes,whichcurtailstheir
desirability.

2.

Ashareofpreferredstockmaybeconsideredahybridsecuritytotheextentthatithassome
characteristicsofbothequityanddebt.Likecommonequity,preferredspaydividendsthatmaybe
passedwhencorporateearningsfallbelowcertainlevels.Theyarealsoissuedwithoutmaturitydates.
Likebonds,thepreferredshareshaveapriorclaimonearningsandassets:thelevelofcurrentincome
isspecifiedforthelifeoftheissueandpreferredsmayhavecallfeaturesandsinkingfundprovisions.
Also,firmscanhaveseveralissuesofpreferredstockoutstandingatthesametime.Themarket
considerspreferredsasfixedincomeobligations,competitivewithbonds,asevidencedbythefact
thatpreferredsusuallysellonayieldbasis.

3.

Advantagesofpreferredstock.
(1) Highcurrentyield,whichisverypredictable
(2) Lowunitcost,sincemostsharesarepricedbetween$25and$100
(3) Safety:sincealmostallqualitypreferredsmeetdividendpaymentsinatimelymanner
(4) Canbeboughtonmargin,withtradingthroughmarketorlimitorders
Disadvantagesofpreferredstock.
(1) Aswithotherfixedincomesecurities,preferredsaresusceptibletotheravagesofhighratesof
inflationandinterest;preferredshavenotproventobeanadequatehedgeagainstinflation
(2) Capitalgainspotentialislowrelativetocommonstock
(3) Preferreddividendsarenotlegallybindingobligationsofthefirm

4.

Cumulativepreferredandcallablepreferredrefertopreferredshareswithtwodifferentprovisions,
eachofwhichaffectstheinvestmentmeritsofpreferredissues.Acumulativeprovisionmeansifany
preferreddividendsarepassed,theymustbepaidinfullbeforeanycommondividendsmaybepaid.
Mostpreferredsarecumulative.Acallablepreferredisoneinwhichthecompanyhastherighttocall
theissueinforretirement;thisrightusuallybecomeseffectiveseveralyears(perhaps57)afterthe
dateofissue.Afterthisdeferralperiod,thepreferredsbecomefreelycallablemeaningtheyare
susceptibletocallifmarketratesdeclinesubstantially.Callablepreferredsarefairlycommontoday.
Otherthingsbeingequal,acumulativepreferredshouldbemorehighlyvaluedthananissuewithout
suchaprovisioni.e.,itshouldraisetheprice/lowertheyieldoftheseissues;incontrast,because
callablepreferredshaveagooddealofcallrisk(i.e.,withacallablepreferred,theresalwaysa
chancetheinvestorwillhavethathighyieldingpreferredcalledaway),theyusuallyprovideahigher
yieldthannoncallablepreferreds.

Chapter12PreferredStocksandConvertibleSecurities227

5.

Thepriceofhighgradepreferredstocksdependsontheannualdollardividendtheypayandtheir
dividendyield.Sincepreferreddividendsarefixed,themarketpriceofpreferredstocksdependson
theirdividendyieldinaninverseway.Inthespecificcaseofhighgradepreferredstocks,theirvalue
iscloselyrelatedtoprevailingmarketinterestrates.Ifthegenerallevelofinterestratesmovesup,so
doestheyieldonpreferredsand,assuch,theirmarketpricesdecline.
Preferredspayaconstantlevelofdividendsforever,sotheycanbeconsideredstockswithzero
dividendgrowthandpricedusingthezerogrowthdividendvaluationmodel:
Price

Annualdividendincome
Prevailingmarketyield

6.

Dividendyieldisthekeytodeterminingthepriceandreturnbehaviorofmostinvestmentgrade
preferredstocks.Becausepreferredsareconsideredtobefixedincomesecurities,onecannormally
expectthepriceofinvestmentgradesecuritiestovaryinverselywithinterestrates.Thus,ifone
expectsthemarketyieldtofall,heorshewouldexpectthepriceofahighgradepreferredtorise.
Thiswouldmaketheissuemoreattractivenotonlywouldoneexpecthighcurrentincomefrom
dividends,butalsoanexpectedcapitalgain.

7.

Severalinvestmentstrategies,bothconservativeandaggressive,areavailableforusewithpreferred
stocks.
(1) Obtainingattractiveyields:Thisconservativestrategy,bestsuitedtoincomeorientedinvestors,
involvesseekingoutthosepreferredswiththehighestyields.Issuequality,callfeature,and
cumulative/participatingcharacteristicsmustbeconsidered.Highqualityissuesarerequiredfor
thisstrategy,sincehighyieldisattractiveonlyifitisactuallyreceived.
(2) Tradingoninterestrates:Thisstrategyadoptsanaggressiveshorttermpostureandattemptsto
capturecapitalgains.Sincepreferredsreacttointerestratechanges,likeanyfixedratesecurity,
theirpricebehavior(atleastforinvestmentgradeissues)iscloselyrelatedtointerestrate
changes.Oneselectshighgradesecuritiestogetmaximuminterestsensitivity,akeyingredient
forthisstrategy.Althoughthisstrategyisalmostthesameforpreferredsasforbonds,preferreds
havelessliberalmarginrequirementsthanbonds.Theselectionprocessissimplerforpreferreds,
sincematurityanddividendsizedonotaffectpricevolatility.
(3) Speculatingonturnarounds:Thisveryaggressivestrategyrequiresfindingfirmsthathave
passedpreferreddividendsandhavehadtheirinvestmentratingslowered;theirpreferredswill
havedepressedprices.Inordertoprofit,however,theinvestormustdeterminewhichofthese
speculativeissuesisabouttoexperienceaturnaroundandbegintopaypreferreddividendsagain.
Somefundamentalanalysisshouldbeperformedtodeterminewhichfirmswillbeabletoagain
servicepreferreddividends.Thisstrategyishighlyrisky,butitdoeshavethepotentialforvery
highreturns.

8.

Aconvertibledebentureisalongterm,unsecuredcorporatebondcarryingtheprovisionthatwithina
stipulatedtimeperiod,thebondmaybeconvertedintoacertainnumberofsharesoftheissuing
corporationscommonstock.Aconvertiblepreferredisverysimilartoaconvertiblebondexceptthat
itisinitiallyissuedasapreferredstockandthenisconvertibleintocommonshares.Thus,a
debentureisabondandapreferredisastock;anotherdifferencebetweenaconvertibledebentureand
convertiblepreferredisthatwhiletheconversionratioofthedebenturegenerallydealswithlarge
multiplesofcommonstock,theconversionratioofapreferredisgenerallyverysmall.Thisis
becausecorporatebondsaresoldin$1,000increments,whilepreferredssellfor$25to$100.

228Gitman/JoehnkFundamentalsofInvesting,NinthEdition

9.

Theequitykickerfeatureofaconvertiblesecuritygivestheinvestoranopportunitytoparticipatein
thepotentialpriceperformanceoftheunderlyingcommonstock.Whenthemarketpriceofthe
commonisequaltoorgreaterthanthestatedconversionprice,theequitykickerhasvaluetothe
investorandthepriceoftheconvertiblewillmovewiththecommon.Whenthepriceofthestock
goesup,thepriceoftheconvertiblewillincreasebyamultiplethatapproximatesitsconversionratio;
likewise,ifthepriceofthestockfalls,theconvertiblewilldeclinebythesamemultiple.(Subjectto
theconversionpricebeinglessthanthestockprice.)

10. Theconvertiblereceivesvaluefrombothitsbondandstockproperties.Attheminimum,thesecurity
isworthwhatitearnsasafixedincomesecurity(presentvalueofinterestandfacevalueatmaturity).
Thisisitsbond(orinvestment)value,anditsetsthepricefloorfortheconvertible.Inaddition,the
securityhasthepotentialtoearnacapitalgainbasedonthefactthatitcanbetradedforafixed
numberofsharesofcommonstock(asspecifiedbytheconversionratio).If,forexample,a$1,000
bondcanbeconvertedinto50sharesofcommonstock,thenasthestockbeginstosellformorethan
$20pershare(theconversionprice),thereisapotentialcapitalgain,andthevalueoftheconvertible
willreflectthis(i.e.,thebehavioroftheunderlyingcommonstock).
11. Aconvertibleissueprovidesattractivecurrentincomeandlimiteddownsiderisk.Itspotentialfor
capitalgainsisvirtuallyunlimitedthoughconvertiblesmustoftenbepurchasedatapremium,
whichhastheobviousdisadvantageofreducingcapitalgainspotential.Thoughitispossibletoreap
thecapitalgainsadvantagesofconvertibleswhilegeneratingimprovedcurrentincome,thesereturns
areusuallynotasgreatasthosefromeitherthedirectpurchaseofcommonstockordebt.Hence
convertiblesofferacombinationofsomeriskprotectionandconsiderableupwardpricepotential.
12. Conversionvalueisanindicationofwhataconvertibleissuewouldtradeforifitspricewerebased
onitsstockvalue.Itisequaltotheconversionratiotimesthecurrentstockprice.Conversionparity
indicatesthepricethecommonstockshouldsellforinordertomaketheconvertibleworthitspresent
marketprice.Itisequaltothecurrentpriceoftheconvertibledividedbytheconversionratio.
Paybackperiodisagoodtooltoassesstheconversionpremiumonconvertibles.Thepaybackperiod
isameasureofthelengthoftimeittakesforthebuyerofaconvertibletorecovertheconversion
premiumfromtheextrainterestincomeearnedontheconvertible.Asaninvestmentrule,everything
elsebeingequal,theshorterthepaybackperiod,thebetter.
Thebondinvestmentvalueofaconvertibleisapriceatwhichthebondwouldtradeifitwere
nonconvertibleandifitwerepricedatorneartheprevailingmarketyieldsofcomparableissues.This
figureindicateshowfartheconvertiblewillhavetofallbeforeithitsitspricefloorandbegins
tradingasastraightdebtinstrument.
13. Sinceaconvertibleissuehasthefeaturesofbothanequityandadebtinstrument,itcanbeusedasif
itwereeitherequityordebt.Convertiblesaremostoftenusedasdeferredequityinvestments.
Investorstrytouseconvertiblestoobtainattractiveequityattributes.Thisstrategyisfollowed
whenevertheunderlyingstockoffersexcellentcapitalgainsopportunities.Oneshouldbesure,when
usingthisstrategy,thatadirectequityinvestmentisnotasuperiorstrategy.Sometimes,convertibles
areusedashighyieldfixedincomeinvestments.Thisapproachisfollowedbythosewhoareheavily
committedtofixedincomesecuritiesandfindhighyieldconvertiblesappealinginvestmentoutlets.
Normally,thoseusingthisstrategygofordiscountissuestradingclosetotheirbondinvestment
values;inthisway,byinvestingintheconvertible,theinvestorgetsanattractivelyyieldingfixed
incomesecurity,andanequitykickertoboot.

Chapter12PreferredStocksandConvertibleSecurities229

Thethreeattributesthatequityorientedinvestorsshouldlookforare:(1)anunderlyingstockthatis
understrongupwardpricepressure,(2)atatimewheninterestratesareexpectedtodropsharply,and
(3)thereislittleornoconversionpremiuminthepriceoftheconvertible.Thefirstfeaturemeans
conversionvalueshouldmoveup,leadingtodesirableappreciationinthepriceoftheconvertible;the
secondmeansthatthebondpricefloorshouldalsomoveup,andtherebyreduceriskexposure;and
thethirdmeansthattheinvestorshouldbeabletocaptureallormostofthepriceappreciationofthe
underlyingcommonstock,ratherthanloseachunkofittotheinevitabledropinconversion
premium.

.5

Suggested Answers to Investing in Action Questions

MIPS: More than Higher Yields and Monthly Income (p. 510)
(a) WhymightinvestorsbeinterestedinbuyingMIPS?
(b) WhataretheunusualrisksassociatedwithMIPS?
Answers:
(a) MonthlyIncomePreferredStocks(MIPS)haveastructurequitedifferentfromaconventional
preferredstock.AconventionalpreferredstockwouldnormallybeissuedbyFirmXYZ,whichneeds
themoney.Ontheotherhand,MIPSareissuedbyalimitedlifecompany(LLC),whichisa
partnershipfirmsetupbyXYZ.LLClendstheproceedsoftheMIPStoXYZandreceivesmonthly
interestpayments,whichgetpassedontotheMIPSholders.
MIPSareattractivetoinvestorsbecausetheyofferhigheryieldsthanCDs,moneymarketmutual
funds,corporatebondsorconventionalpreferredstock.Thedividendpaymentsarealsomade
monthly,whereasbondspayinteresteverysixmonthsandstockspaydividendsquarterly.
(b) Thehigheryieldsareduetohigherriskinvolvedinthesesecurities.Ifanissuer(XYZ)isinfinancial
trouble,MIPSholdershavetostandtowardstheendoftherepaymentline.Ifinterestratesdrop,the
issuercanalsocallthesesecuritiesbackwithoutpayingapenalty.Theincometaxdocumentsthat
MIPSholdersreceivearemorecomplicatedthanconventionalpreferredstock(asMIPSareissuedby
anLLC)andsentoutinmidMarchinsteadoftheendofJanuary.Inaddition,investorshavetokeep
fromconfusingMIPSwithQUIPS,PRIDES,andPINES.

Busted ConvertiblesDown But Not Out (p. 518)

(a) Whatarebustedconvertiblebondsandwhywouldaninvestorconsiderbuyingthistypeofbond?
(b) Whataretherisksofinvestmentinbustedconvertiblebonds?
Answers:
(a) Bustedconvertibleshavenoconversionvalue.Infact,thestockpriceiswellbelowtheconversion
price.Thereportnotesthatoneexpertusesa45%orhigherconversionpremiumasthebenchmarkto
defineabustedconvertible.Nonetheless,thesesecuritieshaveabondfloorforvaluation,whichis
basedonthepresentvalueofthecouponandparvaluecashflows.
Investmentadvantagesincludethehighcurrentyieldarisingfromthelowpriceandthepotentialthat
thesharepricecouldrecover.Forinstance,during2003,thepriceofAmazon.comsurgeduptoover
$61pershare.Inthiscase,therewouldbeboththecurrentincomeandcapitalgainsonrecovering
bustedconvertiblebondvalue.

230Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(b) Bustedconvertiblesexistbecausesharepriceshavedropped.Ifconditionscontinuetosour,the
companymaynotbeabletomakeinterestandparvaluepaymentsinthefuture.Furthermore,listings
onbustedconvertiblesarehardtofindandcommissionsarehigher.Convertiblebondsalsohavebond
ratingsthatarebelowinvestmentgrade,whichlimitstheirliquidity.

.6

Suggested Answers to Discussion Questions

Preferredstockhasapriorclaimonincomeandassets(inbankruptcy)oftheissuingfirm.Italsomay
haveavarietyofspecialfeatures.
1.

(a) Convertiblepreferredgivestheowneranadditionalfeaturethatconvertsthepreferredtoa
commonstock.
(b) Floatingratepreferredsdifferbecausetheygivethesecuritytheabilitytochangetherateof
returnbychangingthedividendtoreflectyieldsinspecificTreasuryissues.
(c) Priorpreferredstockshavethedistinctionthattheyaresenioroverotherpreferredstockbecause
theyhavetherighttoreceivedividendsandhavepriorityinassetliquidation.
(d) Dividendpaymentsontrustpreferredsareexpensedbycorporationsinamannersimilartodebt
interest.Consequently,theIRSdoesnotallowindividualstotreattrustpreferreddividendsas
dividendincomeandutilizethereducedincometaxratesthatapplytootherdividendpayments.
Investorsfindconvertiblepreferredsattractivebecausetheyarelinkedtothecompanyscommon
stockandthebeliefthattheywillprovidepriceappreciationasthecompanybecomesmore
profitable.
Althoughpreferredstockshavethesafetyofaguaranteedannualpayment,thepaymentisfixed.
Hence,asinterestratesrise,thevalueofthefixedpayment(andpreferredstock)declines.
Floatingratesecuritiesoffermoreflexibilityandarenotboundbythefixedrate.
Commonstockpresentsthemostrisktotheinvestor.Ariskaverseinvestormaynotwanttoadd
thisleveloftherisktotheportfolioandwillfindpreferredsmoreacceptable.

2.

Firmsarenotobligatedtomakepreferreddividendpayments.Ifconditionsdeteriorateinafirmtothe
pointwhereitneedstomissoneormoreofitspreferreddividendspayments,mostpreferredstock
issueshavethecumulativerightwhichmeansthatmisseddividendsmustbemadeupinfull.The
rightaffectscommonstockholdersbecauseitrequiresthatmissedpreferredpaymentsmustbepaid
beforedividendscanberestoredtocommonstockholders.Aslongaspreferredstockdividend
paymentsremaininarrears,afirmcannotmakedividendpaymentstocommonshares.

3.

Companiesliketoissueconvertiblesbecausetheconversionfeaturemakesthesecuritymore
attractivetoinvestors.Convertiblesenablethefirmtoraisecapitalatprevailingmarketratesthattake
intoaccounttheunderlyingassetandconversionfeature.Statedanotherway,theadditionalfeature
reducestherequiredrateofreturn,whichincreasesthepricepaidfortheconvertible.
Companiesliketoissuepreferredstocksbecausetheycanraisecapitalandyetnotdilutethe
ownershipandcontrolofthecommonstockholders.Commonstockholderscanmaintaintheirequity
positions,sincepreferredownersdonotreceivetherighttovoteattheannualstockholdersmeeting.

4.

PERCS,whichstandsforpreferredequityredemptioncumulativestock,isatypeofconvertible
preferredthatofferssomethingunusual:anequitykickerandanattractivedividendyield.Thetwo
togetherarenotfoundintheconventionalconvertible.
Althoughtheyofferthestandardfeatureofaconvertiblepreferred,PERCScapitalgainsare
constrained.

Chapter12PreferredStocksandConvertibleSecurities231

LYON,whichstandsforliquidyieldoptionnote,isatypeofconvertiblebondthatcarriesbotha
conversionfeatureandaputoption.Theydifferfromconventionalconvertiblebondsbecausethey
carrytheputoptionthatgivestheownertherighttosellbacktotheissueratprespecifiedprices.
TheinvestorwhobuysPERCShasdecidedthatitismoreimportanttoreceiveanattractivedividend
andlessimportanttoparticipateintheequitykicker.TheinvestorwhobuysLYONSismore
concernedwithanexitstrategy.LYONSgivethatoptionbecauseyouknowthatyoucansellthe
securitieswhenyouwantandatthepriceyouwant.
5.

.7
1.

Answerswillvarybystudent.

Solutions to Problems
Dividendyield=

Annualdividendincome
Preferredstockprice

Price=

Annualdividendincome
Prevailingstockprice

Firstdeterminethecurrentmarketpriceofthestock:
Price

$5.40dividend
$5.40

$60.00
9%dividendyield 0.09

Nowfindthenewdividendyield:
Dividendyield=

$4.50
7.5%
$60.00

Newmarketpriceofpreferredifdividendyieldholdsat9%:
NewPrice

$4.50
$50
0.09

Newmarketpriceofpreferredifyielddropsto7%:
$4.50
NewPrice
$64.29
0.07
2.

Fixedchargecoverage=

Earningsbeforeinterestandtaxes(EBIT)
Interestexpense [Preferreddividends(0.65)]
40,000,000
$2,000,000 ($1,000,000 / 0.65)

40,000,000
11.30times
$2,000,000 $1,538,462
Note:Inthisequation,weuseanassumedcorporatetaxrateof35percent.
SoEBITcouldbereducedbyafactorof11.3timesbeforethefirmwouldbeunabletocoveritsfixed
financialpayments.Note:Intheaboveequation,preferreddividends$2pershare500,000shares
outstanding.

232Gitman/JoehnkFundamentalsofInvesting,NinthEdition

FixedchargecoveragewithEBITDA
Earningsbeforeinterestandtaxes(EBIT) Depreciation Amortization
=
Interestexpense [Preferreddividends(0.65)]
40, 000, 000 5,500, 000

$2, 000,000 ($1, 000, 000 / 0.65)

45,500, 000

12.86times
$2, 000,000 $1,538, 462
Note:Sincedepreciationandamortizationisanoncashexpense,thefirmactuallyhasgreater
coverageofitsinterestexpenseandpreferreddividends.
3.

FixedChargeCoverageEBIT/(InterestExpensePreferredDividends)
FixedChargeCoverage $40,000,000/($2,000,000$500,000$2)
$40,000,000/$3,000,00013.3times
Note:Somestudentsmightcarryoverthe$5,500,000indepreciationandamortizationfromtheprior
problem.Inwhichcase,
FixedChargeCoverage EBITDA/(InterestExpensePreferredDividends)
FixedChargeCoverage $45,500,000/(2,000,000$500,000$2)
$45,500,000/$3,000,00015.17times

4.

HPR(CurrentincomeCapitalgains)/InitialInvestment
(a) Here,Capitalgainsanddividendswouldbetaxedat15%.
Theaftertaxreturnis[(DividendsCapitalGains)0.85]/InitialInvestment
[((100$2)(100$5))0.85]/(100$25)
[$7000.85]/$2500$595/$2,5000.238or23.8%
(b) Here,capitalgainsistaxedat15%,whilethedividendsaretaxedat25%.
Theaftertaxreturnis[(Dividends0.75CapitalGains0.85]/Investment
[(($2000.75)($100$5)0.85]/(100$25)
[$150425]/$2500$575/$2,5000.230or23.0%

5.

Theissuehereisthetaxrateoncommonstockdividendsversustrustpreferredstockdividends.
Commonstockreturn$20.85$1.70aftertax
Preferredstockreturn$2.40.67$1.61aftertax.
Thecommonstockprovidesahigherreturn.

Chapter12PreferredStocksandConvertibleSecurities233

6.

Thereisnosetsolutiontothisproblem,sincetheanswerwillvarywiththepreferredstockchosenby
thestudent.StudentsshouldbeencouragedtogetanactualquotationfromtheWSJtoanswer(a)and
(b).Informationrelevanttoanswer(c),(d),and(e)canbecollectedfromValueLineInvestment
SurveyorStandard&PoorsStockReports.
HereisonesolutionusingConAgras$1.25preferredstock.
(a) Latestmarketprice:$25.30
(b) Dividendyield:$94%($1.25/$25.30)
(c) Dividendpayment:$1.25/4$0.3125
EBIT
(d) Fixedchargecoverage
Interestexpense Pfd.div/0.65
374M
68.2M 4.8M / 0.65
$5.12
BVofcommon BVofpreferred

No.ofpreferredsharesoutstanding

(e) Bookvalue(BV)

$4898M $60M
25Mshares
$198.32pershare

(f) $1.32parvalue
[Sourceford,e,f:ConAgras10afiled1/5/04]
ThefixedchargecoverageofBFConAgrasinterestexpenseanddividendpaymentisverystrong.
EBITisalmostthreetimestheneededamount.Sincethereisoverseventimesasmuchcommon
stockaspreferredstock,thepreferredstocksbookvalueisquitehighrelativetoitsparvalue.
7.

ForSarJspreferredstock:
Annualdividendincome
Prevailingmarketyield
$3.50

$46.67
7.5%
PriceusingthedividendvaluationmodelfromChapter8:
Price

Dividend
wherek requiredrateofreturn
k
$3.50

$46.67
7.5%

Price

Bothmethodsyieldthesameresults:thefirstmethodusestheperpetuitymodelforvaluingthe
preferredstock.Thesecondusesthezerogrowthvaluationmodel;whenthegrowthrateiszero,it
becomesaperpetuityalso.Therequiredrateofreturnforpreferredstocksistheprevailingmarket
yield.

234Gitman/JoehnkFundamentalsofInvesting,NinthEdition

8.

First,findthefuturemarketpriceofthepreferredifitsyieldfallsto6%:
Annualdividendincome
$7

Futuremarketyield
0.065
$107.69or$108
Now,findtheexpectedrealizedyieldaccordingtotheformulainthechapter.
ExpectedRealizedYield:
Letr%betheexpectedrealizedyield.Wehave
Price

757PVIFAr%,2yrs.108PVIFr%,2yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,the
realizedyield28.6%
Ifthedropinratestakesplaceinoneyear,theexpectedrealizedyieldcanbecalculatedusingthe
holdingperiodreturnformula:
Annualdividend Futureprice Currentprice
CurrentPrice
$7 $108 $75 $7 $33

53.33%
$75
$75

Expectedrealizedyield

9.

ConversionEquivalentConversionratioMarketprice21$40$840.

10. Commonstock:$850/$2534shares
Commonstockprofit($35$25)34shares$340
Convertibleprofit(($50(34$35))850$1240850$390
Buytheconvertiblebond
11. Convertiblebond:$1,000facevalue,6%coupon,20yearmaturity,convertibleinto20shares;
currentpriceoftheconvertibleis$800,currentstockpriceis$35.
(a) Currentyield
=Currentincome/Currentprice
=[(0.06)($1,000)]/$8007.5%
(b) Conversionprice
Parvalue/Conversionratio
$1,000/20$50/share
(c) Conversionratio
Statednumberofsharesthebondcanbeconvertedinto
20shares
(d) Conversionvalue
ConversionratioMarketpriceofthestock
20$35$700
Conversionparity
Marketpriceoftheconvertible
=
Conversionratio
$800/20$40
(e) Conversionpremium CurrentmarketpriceofconvertibleConversionvalue
$800$700$100
Conversionpremium $100/$70014.29%

Chapter12PreferredStocksandConvertibleSecurities235

(f) PaybackPeriod

Conversionpremium(in$)
Annualinterest
Annualdividend
incomefromincomefrom
convertiblebondunderlyingCS
$100
$100

$60 (20 0.75) $60 $15

2.2years
(g) YieldtoMaturity
Letr%betheyieldtomaturity.Wehave
80060PVIFAr%,20yrs.1,000PVIFr%,20yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usinga
financialcalculator,therealizedyield8.04%
(h) InvestmentvalueValueasastraight(nonconvertible)bond
$60PVIFA8%,20yrs.$1,000PVIF8%,20yrs.
$609.818$1,0000.215
$589.08$215$804.08
Sotheconvertibleissellingatitsfloororatitsvalueasabond.
12. Priceofconvertibleinoneyearwillbe10percentovertheconversionvalue.
PriceofstockConversionratio
$7520$1,500
Priceofconvertible
$1,50010%of$1,500
$1,500$150$1,650(in1yr)
Now,with$5,000aninvestorcanbuy5bondspricedat$1,000each.Therefore:
Conversionvalue

Interest(coupon)income

($1,0000.08)5
$80perbond5$400

Capitalgains

($1,650$1,000)5

236Gitman/JoehnkFundamentalsofInvesting,NinthEdition

$650perbond5$3,250
Totalincome
$400$3,250$3,650
1yearholdingperiodreturn$3,650/$5,00073%
Giventheconvertibleissellingatapriceof$1,000,whichincludesa25%conversionpremium:
Conversionvalueofthesecurity$1,000/1.25$800
(Afactorof1.25isusedinthisformulasince,witha25%conversionpremium,thepriceofthe
convertiblewillbeequalto125%oftheconversionvalue.)
Conversionvalue
Security'sconversionratio
$800 / 20 $40/share

Priceofunderlyingcommonstock

Note:Thisproblemshowsthat,whilethepriceoftheconvertiblewentupby65%overthecourseof
theyear(from$1,000to$1,650),thepriceoftheunderlyingcommonstockwentupevenmore:
87.5%(from$40to$75).Thereasonforthis,ofcourse,isthedropintheconversionpremium(from
25%to10%)i.e.,thisrepresentslostprofits,whichacttoreducetherateofpriceappreciationof
theconvertibleissue(apointofwhichstudentsshouldbemadewellaware,sincethismajor
drawbackisacommonfeatureofconvertiblesecurities).
13. Theinvestmentvalueofaconvertiblebondisdonebypricingthebondatarateequal(orclose)to
theprevailingmarketyieldforcomparablenonconvertibleissues.Inthiscase:
InvestmentValue

14. Conversionvalue

InterestincomePVIFAk%,nyrs.MaturitypaymentPVIFk%,nyrs.
$75PVIFA9%,15yrs.$1,000PVIF9%,15yrs.
$75(8.061)$1,000(0.275)
$879.58
ConversionratioPriceofcommonstock

1.8$40$72
Conversionpremium MarketpriceConversionvalue
$90$72$18
Sothereisaconversionpremiumof$18or25%($18/$72).
Marketpriceofconvertible
Conversionparity
Conversionratio
$90
$50

1.8
Conversionparityisthepricethecommonstockwouldhavetosellforinordertomakethe
convertiblesecurityworthitspresentmarketvalue.Thedifferencebetweentheconversionparityand
theactualmarketpriceofthecommon($40)isthecurrentconversionpremiumpershareof$10($50
$40)or25%($10/$40).

.8

Solutions to Case Problems

Chapter12PreferredStocksandConvertibleSecurities237

Case 12.1Penni Shows a Preference for Preferreds

Thiscaseisdesignedtohavethestudentmakedecisionsaboutpreferredstocks.Bothcomputationsand
discussionsabouttheinvestmentmeritsofpreferredsareinvolved.
(a) Pennisstockbrokerexpectsthemarketyieldtodropto7percentintwoyears.
PriceDividend/MarketYield
$5.00/0.07$71.43
ThusthepriceoftheLaRamiepreferredshouldrisefrom$48toabout71.50inthreeyears.
(b) ExpectedRealizedYield:
Letr%betheexpectedrealizedyield.Wehave
485PVIFAr%,3yrs.71.50PVIFr%,3yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,the
realizedyield23.4%
Shestandstomake$500/yearindividendsfor3years,pluscapitalgainsof$2,350[($71.50$48)
100shares],foratotalprofitof$3,850(5005005002,350)allfromaninvestmentof$4,800
(or100sharesofthepreferredstock).
(c) TherealizedyieldMs.Jockcanexpectfromthispreferredstockis35.3percent.Heralternative
investmentoffersanannualrateofonly10percent.Ifthetwoalternativeshavecomparablerisk
exposure,theLaRamieMine$5preferredisclearlythesuperiorinvestmentandthereforesheshould
seriouslyconsiderbuyingit.
(d) Whilethismaybeaqualitypreferredstock,thewayitisbeingused(speculatingoninterestrate
movements)placestheinvestorinahighlyriskyposition.Itoffersaveryattractiverateofreturn.
Evenso,wecannotlosesightofthefactthatthesecurityoffersahighbutcertainlynotaguaranteed
rateofreturn.Soconsiderationofitsrisksshouldbetakenintoaccount.Ifthemarketyielddoesnot
fallto7percent,thepriceofthestockwillnotrise.Thentheyieldwillonlybeits10.4percentcurrent
yieldhowever,notethatthisisstillsuperior(albeitmarginally)toheralternativeinvestment
opportunity.IfLaRamiehasbusinesslosses,itmayhavetopassitsdividendinoneormorequarters,
causingtheyieldtobeevenlower.Worseyet,ifinterestratesactuallyincrease,themarketpriceof
thestockwillfall,ratherthanrise.Thiscouldresultinalow,orevennegative,investmentyield.
(Remember,however,thispreferredhascomparableriskwiththealternativeinvestment,anditdoes
haveahigherexpectedreturn,soitistherecommendedchoice.Studentsdoneedtobeawareofthe
risksinvolved,andthisshouldbebroughtintothediscussion.)

Case 12.2Dave and Marlene Consider Convertibles

Thiscaseinvolvestheanalysisofaconvertiblebond;itconsidersthemeritsofaconvertibleasanequity
basedinvestment,butalsopointsouttheimportantrolethatthebonddimensionplaysinthevaluation
process,particularlywithregardtoexposuretorisk.Indiscussingthiscase,theinstructorshould
emphasizetheimportanceofanalyzingtheunderlyingcommonstockandformulatinginterestrate
expectationsafterall,itsultimatelythestockandbonddimensionsoftheconvertiblewhichgivesthe
securityitsvalue!!(Note,inthecase,weassumeDaveand/orMarlenehavealreadythoroughlyanalyzed
theunderlyingcommonstockandexaminedthecurrentstatus/futuredirectionofinterestrates.)
(a) Ifweignoreconversionpremium,thesecuritieswouldbepricedattheirconversionvalue(i.e.,
conversionratiomarketpriceofthestock);thus:
withthecommonat$66.67/share,theconvertiblewouldbepricedat:

238Gitman/JoehnkFundamentalsofInvesting,NinthEdition

15$66.67$1,000.00
withthecommonat$75/share,theconvertiblewouldbepricedat:
15$75$1,125.00
withthecommonat$100/share,theconvertiblewouldbepricedat:
15$100$1,500.00
Witha5%conversionpremium,theconvertiblewouldbepricedat105%ofitsrespectiveconversion
value,ascomputedabove;thatis,
withthecommonat$66.67/share: (15$66.67)1.05 $1,050.00
withthecommonat$75/share:
(15$75)1.05
$1,181.25
withthecommonat$100/share: (15$100)1.05 $1,575.00
(b) Usingthepromisedyieldformulawehave
Letr%bethepromisedyield.
80075PVIFAr%,20yrs.1,000PVIFr%,20yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,the
realizedyield9.82%

Chapter12PreferredStocksandConvertibleSecurities239

(1) Atan8%marketrate,thebondvalueoftheconvertibleis:
BondValue AnnualInterestIncomePVIFA8%,18yrs.1,000PVIF8%,18yrs.
$759.3721,0000.250
$702.90$250.00$952.90
Ata6%marketrate,thebondvalueis:
BondValue $75PVIFA6%,18yrs.$1,000PVIF6%,18yrs.
$75(10.828)$1,000(0.350)
$812.10$350.00$1,162.10
(2) Adropininterestratesmeansthatregardlessofwhathappenstothepriceoftheunderlyingstock,
thepriceoftheconvertiblewillrise(inessence,thepricefloorwillriseastheconvertiblederives
valuefromitsbonddimension).Note,forexample,intheproblemabovethatifinterestratesdo
fallto6%,thepriceoftheconvertiblewillincreasefrom$800(itspresentprice)to$1,162and
thisistotallyindependentofwhathappenstothepriceofthestock!Andevenifinterestratesonly
dropto8%,thepriceoftheconvertiblewillstillgoup(from$800to$952).Forthisreason,a
dropinratesreducestheinvestorsexposuretorisk.
(c) Theminimumfutureconvertiblepricewecalculatedaboveis$1,000(giventhereisnoconversion
premiumandthepriceofthecommonrisesto$66.67/share);therefore,theminimumexpectedyield
wouldbe:
Letr%bethepromisedyield.
80075PVIFAr%,2yrs.$1,000PVIFr%,2yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,the
realizedyield20.7%
Themaximumfutureconvertiblepricewecalculatedaboveis$1,500(giventhestockmovesto
$100/share);thus,maximumexpectedyieldwouldbe:
Letr%bethepromisedyield.
80075PVIFAr%,2yrs.$1,500PVIFr%,2yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,the
realizedyield45%
(1) Ifthepriceofthestockdropsto$40andinterestratesdropto9%,theconvertiblewouldtradeas
abondanditspricein2yearswouldbe:
BondValue $75PVIFA9%,18yrs.$1,000PVIF9%,18yrs.
$758.756$1,0000.212$868.70
(Note:at$40/share,theconversion(stock)valueofthesecuritywouldbe:15$40$600,
whichisconsiderablylessthanitsbondvalue.)
Letr%bethepromisedyield.
80075PVIFAr%,2yrs.868.70PVIFr%,2yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,
therealizedyield13.4%
Thus,evenundertheseconditions,thereturnisstillfairlyattractive.

240Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(2) Ifthepriceofthestockdropsto$40andinterestratesriseto11%,boththestockandthebond
valuesofthesecuritywoulddrop;theconversionvalue(perabove)wouldbe$600andthebond
valuewouldbe:
BondValue $75PVIFA11%,18yrs.$1,000PVIF11%,18yrs.
$757.702$1,0000.153$730.65
Asabove,theconvertiblewouldstilltradeasabond,butthistimetherewouldbeacapitalloss
asthepriceoftheconvertibledropsoverthe2yearholdingperiodfrom$800to$730.65.Under
theseconditions,theconvertibleofferslittleinvestmentappealasithasapotentialexpectedyield
ofonly5.14%).
Letr%betheexpectedyield.
80075PVIFAr%,2yrs.730.65PVIFr%,2yrs.
UsingTables,therealizedyieldcanbecalculatedbytrialanderror.Usingafinancialcalculator,
therealizedyield5.14%
(d) IfDaveandMarlenesexpectationsareright,thisconvertiblecouldwellofferthebestofbothworlds:
thechancetoparticipateincapitalgainsviatheequitykickerandatreducedexposuretoriskasthe
bondpricefloorincreasesaswell.Asindicatedabove,therangeofpossiblereturnsoverthenext2
yearsfromthisinvestmentisexcellent;i.e.,20.4%to45%.Ofcourse,ifthingsdontpanout,thenthe
resultsmaynotturnoutsorosyafterall.However,inthiscase,thebiggestriskliesinthefuture
behaviorofinterestratesandevenhere,theyregoingtohavetorisebyabout160basispoints(from
theircurrentlevelof9.4%to11%)beforetheinvestmentturnssourrecallthatat11%,theexpected
yieldfromtheconvertibleisonly5.14%.Thus,theinvestmentinthesemedtechconvertibleslooks
attractiveandisdefinitelyoneDaveandMarleneshouldseriouslyconsider.

.9

Outside Project

Chapter 12What Makes Convertibles Tick?

Thevalueofaconvertiblebondorconvertiblepreferredisafunctionoftheoutlookforthemarketsin
fixedincomesecurities(bondsandpreferreds)andincommonstocks.Therefore,anyonewhoinvestsin
convertiblesmustbefamiliarwithinterestrates/inflationexpectations,theoutlookforthestockmarket,
andthefutureprospectsoftheunderlyingcommonstock.Thepurposeofthisprojectistogiveyousome
insightintohowconvertibleschangeinvaluerelativetosomeofthesevariables.
GotothelibraryandobtainacopyofBarronsorTheWallStreetJournalthatsaboutayearold,and
fromoneofthesesources,selecttwoconvertiblebondsandtwoconvertiblepreferredsthatarestilltraded
today.Onceyouhaveselectedthesecurities,lookuptheirconversionfeaturesinsomethinglike
MergentsorS&Psothattheycanbeanalyzed.Inparticular,calculatethefollowing:
1. Currentyield
2. Conversionvalue
3. Conversionparty
4. Conversionpremium,indollarsandpercent
5. Paybackperiod
6. Investmentvalueoftheconvertibles
7. Dividendyieldonthecommonstock

Chapter12PreferredStocksandConvertibleSecurities241

Calculatethesemeasuresforayearagoversuswhattheyaretoday.(Note:Recallthatinvestmentvalueat
anytimedependsonthecurrentmarketratethatwouldapplytoanonconvertiblefixedincomesecurity
withthesameagencyrating.YoucanfindtheseratesinpublicationslikeMergentsBondRecordorS&P
BondGuide.)Inaddition,calculatetheholdperiodreturn(overtheoneyearperiodoftimeusedinyour
analysis)foreachofthefourconvertiblesandtheirrespectiveunderlyingcommonstocks.
Nowthatyouhaveinformationforthelasttwelvemonths,describewhathashappenedtothevalueofthe
convertible.Howdoestheperformanceoftheconvertiblecomparetowhatshappenedinthebondmarket
overthepast12monthsandtowhatshappenedwiththestocks?Commentonyourfindings.