1
238Gitman/JoehnkFundamentals of Investing, Ninth Edition
Chapter 12Preferred Stocks and Convertible Securities239
Chapter 12Preferred Stocks and Convertible
Securities(OutlineLearning GoalsI.Preferred StocksA)Preferred
Stocks as Investment Vehicles1.Advantages and
Disadvantages2.Sources of Value3.Risk Exposure4.Market
TransactionsB)Issue Characteristics1.Rights of Preferred
Stockholders2.Preferred Stock ProvisionsConcepts in
ReviewII.Valuing and Investing in PreferredsA)Putting a Value on
Preferreds1.Dividend Yield: A Key Measure of Value2.Expected
Return3.Book Value4.Fixed Charge Coverage5.Agency
RatingsB)Investment Strategies1.Looking for Yields2.Trading on
Interest Rate Swings3.Speculating on Turnarounds4.Investing in
Convertible PreferredsConcepts in ReviewIII.Convertible
SecuritiesA)Convertibles as Investment Outlets1.Convertible Notes
and Bonds2.Conversion Privilege3.Percs and LyonsB)Sources of
ValueC)Advantages and Disadvantages of Investing in
ConvertiblesD)Executing TradesConcepts in ReviewIV.Valuing and
Investing in ConvertiblesA)Measuring the Value of a
Convertible1.Conversion Valuea.Conversion Premiumb.Payback
Period2.Investment ValueB)An Overview of Price and Investment
BehaviorC)Investment Strategies1.Convertibles as Deferred Equity
Investments2.A Measure of Expected Return3.Some Important
Considerations4.Convertibles as High-Yield Fixed-Income
InvestmentsConcepts in ReviewSummaryPutting Your Investment
Know-How to the TestDiscussion QuestionsProblemsCase
Problems12.1.Penni Shows a Preference for Preferreds12.2.Dave and
Marlene Consider ConvertiblesExcel with SpreadsheetsTrading Online
with OTIS(Key Concepts1.The fundamental aspects of preferred stock,
including sources of value and risk.2.Basic rights and claims of
preferred stockholders, and some of the popular characteristics
often found with these securities.3.Various measures of investment
suitability and several preferred stock investment
strategies.4.General characteristics of convertible securities and
the conversion privilege.5.The advantages and disadvantages of
investing in convertibles, including their risk and return
characteristics.6.The evaluation of convertible security returns
and the investment techniques that can be used with these
securities.(OverviewSome special types of fixed-income
securitiespreferred stocks and convertiblesare discussed in this
chapter. Preferred stocks are treated first, then
convertibles.1.Preferred stocks are defined. Preferred stocks
usually have fixed dividend characteristics. It might be pointed
out that high current income is an advantage of this investment
vehicle. Since most of the preferred shares outstanding can be
classified as debt on issuers financial reports (and tax
deductible), most preferred stock dividends do not qualify for the
new preferential tax rate. It might be useful to show how to read
preferred stock quotations in the financial pages of the
WSJ.2.Issue characteristics, investor rights and claims, cumulative
provisions and call and sinking fund provisions are considered.
Cumulative provisions are important and distinctive features of
preferred stocks that should be explained in detail.
Adjustable-rate preferreds and preference preferreds are also
introduced and briefly discussed.3.The next section outlines some
ways of evaluating preferred stock for investment purposes. At this
stage, the following concepts should be reviewed carefully: how to
calculate the expected yield of a particular stock, how to reach an
investment decision regarding that stock, and what preferred stock
agency ratings mean and where to obtain them. The instructor should
explain to the class that the value of investment-grade preferred
stocks fluctuates with the market rate of interest and demonstrate
the inverse relationship with a specific example.4.Convertibles
possess features of both fixed-income securities and equity. The
meaning of equity kicker may be explained. Students should be made
aware that either bonds or preferred stocks can be issued as
convertible securities. The advantages and disadvantages of
convertible securities should be highlighted.5.The next section
deals with valuing convertibles. It should be emphasized how
conversion value and conversion premium are important in affecting
the price and return performance of a convertible.6.Investment
strategies related to convertibles are discussed next. Students
should understand that convertibles provide good upside potential
through their equity feature and downside protection through their
fixed income properties. Additionally, it should also be shown that
convertibles may be used for either capital gains or current
income. The instructor might point out that convertibles are
popular as investment vehicles because they include the features of
both stocks and bonds. Presentation of the payback period provides
clarity regarding conversion premium disadvantages and comparative
current cash flow advantages of convertible securities.(Answers to
Concepts in Review1.Preferred stocks are equity issues that hold a
position senior to common stock. Even though preferred shares are a
form of equity, they are considered fixed-income securities because
their level of current income is usually fixed. This current income
(dividend payments) is typically paid quarterly and has priority
over common dividend payments; that is, all preferred dividends
must be paid before any payment to common stockholders may be made.
Also, in the event of bankruptcy, the claims of preferred
stockholdersup to the par or stated value of the securitiesmust be
satisfied prior to any claims of common stockholders.
Some preferred stock dividends are treated as a financing cost
and are tax deductible at the corporate level. These preferred
shares are known as trust preferred stocks. They do not qualify for
the new preferential tax rate of fifteen percent or less on
individual income taxes, which curtails their desirability.2.A
share of preferred stock may be considered a hybrid security to the
extent that it has some characteristics of both equity and debt.
Like common equity, preferreds pay dividends that may be passed
when corporate earnings fall below certain levels. They are also
issued without maturity dates. Like bonds, the preferred shares
have a prior claim on earnings and assets: the level of current
income is specified for the life of the issue and preferreds may
have call features and sinking fund provisions. Also, firms can
have several issues of preferred stock outstanding at the same
time. The market considers preferreds as fixed-income obligations,
competitive with bonds, as evidenced by the fact that preferreds
usually sell on a yield basis.3.Advantages of preferred
stock.(1)High current yield, which is very predictable(2)Low unit
cost, since most shares are priced between $25 and $100(3)Safety:
since almost all quality preferreds meet dividend payments in a
timely manner(4)Can be bought on margin, with trading through
market or limit orders
Disadvantages of preferred stock.(1)As with other fixed-income
securities, preferreds are susceptible to the ravages of high rates
of inflation and interest; preferreds have not proven to be an
adequate hedge against inflation(2)Capital gains potential is low
relative to common stock(3)Preferred dividends are not
legally-binding obligations of the firm4.Cumulative preferred and
callable preferredrefer to preferred shares with two different
provisions, each of which affects the investment merits of
preferred issues. A cumulative provision means if any preferred
dividends are passed, they must be paid in full before any common
dividends may be paid. Most preferreds are cumulative. A callable
preferred is one in which the company has the right to call the
issue in for retirement; this right usually becomes effective
several years (perhaps 57) after the date of issue. After this
deferral period, the preferreds become freely callablemeaning they
are susceptible to call if market rates decline substantially.
Callable preferreds are fairly common today.
Other things being equal, a cumulative preferred should be more
highly valued than an issue without such a provisioni.e., it should
raise the price/lower the yield of these issues; in contrast,
because callable preferreds have a good deal of call risk (i.e.,
with a callable preferred, theres always a chance the investor will
have that high yielding preferred called away), they usually
provide a higher yield than noncallable preferreds.5.The price of
high-grade preferred stocks depends on the annual dollar dividend
they pay and their dividend yield. Since preferred dividends are
fixed, the market price of preferred stocks depends on their
dividend yield in an inverse way. In the specific case of
high-grade preferred stocks, their value is closely related to
prevailing market interest rates. If the general level of interest
rates moves up, so does the yield on preferreds and, as such, their
market prices decline.
Preferreds pay a constant level of dividends forever, so they
can be considered stocks with zero dividend growth and priced using
the zero-growth dividend valuation model:
6.Dividend yield is the key to determining the price and return
behavior of most investment-grade preferred stocks. Because
preferreds are considered to be fixed-income securities, one can
normally expect the price of investment-grade securities to vary
inversely with interest rates. Thus, if one expects the market
yield to fall, he or she would expect the price of a high-grade
preferred to rise. This would make the issue more attractivenot
only would one expect high current income from dividends, but also
an expected capital gain.7.Several investment strategies, both
conservative and aggressive, are available for use with preferred
stocks.(1)Obtaining attractive yields: This conservative strategy,
best suited to income-oriented investors, involves seeking out
those preferreds with the highest yields. Issue quality, call
feature, and cumulative/participating characteristics must be
considered. High-quality issues are required for this strategy,
since high yield is attractive only if it is actually
received.(2)Trading on interest rates: This strategy adopts an
aggressive short-term posture and attempts to capture capital
gains. Since preferreds react to interest rate changes, like any
fixed rate security, their price behavior (at least for investment
grade issues) is closely related to interest rate changes. One
selects high-grade securities to get maximum interest sensitivity,
a key ingredient for this strategy. Although this strategy is
almost the same for preferreds as for bonds, preferreds have less
liberal margin requirements than bonds. The selection process is
simpler for preferreds, since maturity and dividend size do not
affect price volatility.(3)Speculating on turnarounds: This very
aggressive strategy requires finding firms that have passed
preferred dividends and have had their investment ratings lowered;
their preferreds will have depressed prices. In order to profit,
however, the investor must determine which of these speculative
issues is about to experience a turnaround and begin to pay
preferred dividends again. Some fundamental analysis should be
performed to determine which firms will be able to again service
preferred dividends. This strategy is highly risky, but it does
have the potential for very high returns.8.A convertible debenture
is a long-term, unsecured corporate bond carrying the provision
that within a stipulated time period, the bond may be converted
into a certain number of shares of the issuing corporations common
stock. A convertible preferred is very similar to a convertible
bond except that it is initially issued as a preferred stock and
then is convertible into common shares. Thus, a debenture is a bond
and a preferred is a stock; another difference between a
convertible debenture and convertible preferred is that while the
conversion ratio of the debenture generally deals with large
multiples of common stock, the conversion ratio of a preferred is
generally very small. This is because corporate bonds are sold in
$1,000 increments, while preferreds sell for $25 to $100.9.The
equity kicker feature of a convertible security gives the investor
an opportunity to participate in the potential price performance of
the underlying common stock. When the market price of the common is
equal to or greater than the stated conversion price, the equity
kicker has value to the investor and the price of the convertible
will move with the common. When the price of the stock goes up, the
price of the convertible will increase by a multiple that
approximates its conversion ratio; likewise, if the price of the
stock falls, the convertible will decline by the same multiple.
(Subject to the conversion price being less than the stock
price.)10.The convertible receives value from both its bond and
stock properties. At the minimum, the security is worth what it
earns as a fixed-income security (present value of interest and
face value at maturity). This is its bond (or investment) value,
and it sets the price floor for the convertible. In addition, the
security has the potential to earn a capital gain based on the fact
that it can be traded for a fixed number of shares of common stock
(as specified by the conversion ratio). If, for example, a $1,000
bond can be converted into 50 shares of common stock, then as the
stock begins to sell for more than $20 per share (the conversion
price), there is a potential capital gain, and the value of the
convertible will reflect this (i.e., the behavior of the underlying
common stock).11.A convertible issue provides attractive current
income and limited downside risk. Its potential for capital gains
is virtually unlimitedthough convertibles must often be purchased
at a premium, which has the obvious disadvantage of reducing
capital gains potential. Though it is possible to reap the capital
gains advantages of convertibles while generating improved current
income, these returns are usually not as great as those from either
the direct purchase of common stock or debt. Hence convertibles
offer a combination of some risk protection and considerable upward
price potential.12.Conversion value is an indication of what a
convertible issue would trade for if its price were based on its
stock value. It is equal to the conversion ratio times the current
stock price. Conversion parity indicates the price the common stock
should sell for in order to make the convertible worth its present
market price. It is equal to the current price of the convertible
divided by the conversion ratio.
Payback period is a good tool to assess the conversion premium
on convertibles. The payback period is a measure of the length of
time it takes for the buyer of a convertible to recover the
conversion premium from the extra interest income earned on the
convertible. As an investment rule, everything else being equal,
the shorter the payback period, the better.
The bond investment value of a convertible is a price at which
the bond would trade if it were nonconvertible and if it were
priced at or near the prevailing market yields of comparable
issues. This figure indicates how far the convertible will have to
fall before it hits its price floor and begins trading as a
straight debt instrument.13.Since a convertible issue has the
features of both an equity and a debt instrument, it can be used as
if it were either equity or debt. Convertibles are most often used
as deferred equity investments. Investors try to use convertibles
to obtain attractive equity attributes. This strategy is followed
whenever the underlying stock offers excellent capital gains
opportunities. One should be sure, when using this strategy, that a
direct equity investment is not a superior strategy. Sometimes,
convertibles are used as high-yield fixed income investments. This
approach is followed by those who are heavily committed to
fixed-income securities and find high-yield convertibles appealing
investment outlets. Normally, those using this strategy go for
discount issues trading close to their bond investment values; in
this way, by investing in the convertible, the investor gets an
attractively yielding fixed-income security, and an equity kicker
to boot.
The three attributes that equity-oriented investors should look
for are: (1) an underlying stock that is under strong upward price
pressure, (2) at a time when interest rates are expected to drop
sharply, and (3) there is little or no conversion premium in the
price of the convertible. The first feature means conversion value
should move up, leading to desirable appreciation in the price of
the convertible; the second means that the bond price floor should
also move up, and thereby reduce risk exposure; and the third means
that the investor should be able to capture all or most of the
price appreciation of the underlying common stock, rather than lose
a chunk of it to the inevitable drop in conversion
premium.(Suggested Answers to Investing in Action QuestionsMIPS:
More than Higher Yields and Monthly Income (p. 510)(a)Why might
investors be interested in buying MIPS?(b)What are the unusual
risks associated with MIPS?Answers:(a)Monthly Income Preferred
Stocks (MIPS) have a structure quite different from a conventional
preferred stock. A conventional preferred stock would normally be
issued by Firm XYZ, which needs the money. On the other hand, MIPS
are issued by a limited-life company (LLC), which is a partnership
firm set up by XYZ. LLC lends the proceeds of the MIPS to XYZ and
receives monthly interest payments, which get passed on to the MIPS
holders.MIPS are attractive to investors because they offer higher
yields than CDs, money market mutual funds, corporate bonds or
conventional preferred stock. The dividend payments are also made
monthly, whereas bonds pay interest every six months and stocks pay
dividends quarterly. (b)The higher yields are due to higher risk
involved in these securities. If an issuer (XYZ) is in financial
trouble, MIPS holders have to stand towards the end of the
repayment line. If interest rates drop, the issuer can also call
these securities back without paying a penalty. The income tax
documents that MIPS holders receive are more complicated than
conventional preferred stock (as MIPS are issued by an LLC) and
sent out in mid-March instead of the end of January. In addition,
investors have to keep from confusing MIPS with QUIPS, PRIDES, and
PINES. Busted ConvertiblesDown But Not Out (p. 518)(a)What are
busted convertible bonds and why would an investor consider buying
this type of bond?(b)What are the risks of investment in busted
convertible bonds?Answers:(a)Busted convertibles have no conversion
value. In fact, the stock price is well below the conversion price.
The report notes that one expert uses a 45% or higher conversion
premium as the benchmark to define a busted convertible.
Nonetheless, these securities have a bond floor for valuation,
which is based on the present value of the coupon and par value
cash flows. Investment advantages include the high current yield
arising from the low price and the potential that the share price
could recover. For instance, during 2003, the price of Amazon.com
surged up to over $61 per share. In this case, there would be both
the current income and capital gains on recovering busted
convertible bond value.(b)Busted convertibles exist because share
prices have dropped. If conditions continue to sour, the company
may not be able to make interest and par value payments in the
future. Furthermore, listings on busted convertibles are hard to
find and commissions are higher. Convertible bonds also have bond
ratings that are below investment grade, which limits their
liquidity. (Suggested Answers to Discussion QuestionsPreferred
stock has a prior claim on income and assets (in bankruptcy) of the
issuing firm. It also may have a variety of special features.
1.(a)Convertible preferred gives the owner an additional feature
that converts the preferred to a common stock.(b)Floating-rate
preferreds differ because they give the security the ability to
change the rate of return by changing the dividend to reflect
yields in specific Treasury issues.(c)Prior preferred stocks have
the distinction that they are senior over other preferred stock
because they have the right to receive dividends and have priority
in asset liquidation.(d)Dividend payments on trust preferreds are
expensed by corporations in a manner similar to debt interest.
Consequently, the IRS does not allow individuals to treat trust
preferred dividends as dividend income and utilize the reduced
income tax rates that apply to other dividend payments.
Investors find convertible preferreds attractive because they
are linked to the companys common stock and the belief that they
will provide price appreciation as the company becomes more
profitable.
Although preferred stocks have the safety of a guaranteed annual
payment, the payment is fixed. Hence, as interest rates rise, the
value of the fixed payment (and preferred stock) declines. Floating
rate securities offer more flexibility and are not bound by the
fixed rate.
Common stock presents the most risk to the investor. A risk
averse investor may not want to add this level of the risk to the
portfolio and will find preferreds more acceptable.2.Firms are not
obligated to make preferred dividend payments. If conditions
deteriorate in a firm to the point where it needs to miss one or
more of its preferred dividends payments, most preferred stock
issues have the cumulative right which means that missed dividends
must be made up in full. The right affects common stockholders
because it requires that missed preferred payments must be paid
before dividends can be restored to common stockholders. As long as
preferred stock dividend payments remain in arrears, a firm cannot
make dividend payments to common shares. 3.Companies like to issue
convertibles because the conversion feature makes the security more
attractive to investors. Convertibles enable the firm to raise
capital at prevailing market rates that take into account the
underlying asset and conversion feature. Stated another way, the
additional feature reduces the required rate of return, which
increases the price paid for the convertible.
Companies like to issue preferred stocks because they can raise
capital and yet not dilute the ownership and control of the common
stockholders. Common stockholders can maintain their equity
positions, since preferred owners do not receive the right to vote
at the annual stockholders meeting.4.PERCS, which stands for
preferred equity redemption cumulative stock, is a type of
convertible preferred that offers something unusual: an equity
kicker and an attractive dividend yield. The two together are not
found in the conventional convertible.
Although they offer the standard feature of a convertible
preferred, PERCS capital gains are constrained.
LYON, which stands for liquid yield option note, is a type of
convertible bond that carries both a conversion feature and a put
option. They differ from conventional convertible bonds because
they carry the put option that gives the owner the right to sell
back to the issuer at prespecified prices.
The investor who buys PERCS has decided that it is more
important to receive an attractive dividend and less important to
participate in the equity kicker. The investor who buys LYONS is
more concerned with an exit strategy. LYONS give that option
because you know that you can sell the securities when you want and
at the price you want.5.Answers will vary by student.(Solutions to
Problems1.Dividend yield =
Price =
First determine the current market price of the stock:
Now find the new dividend yield:
New market price of preferred if dividend yield holds at 9%:
New market price of preferred if yield drops to 7%:
2.
Note: In this equation, we use an assumed corporate tax rate of
35 percent.So EBIT could be reduced by a factor of 11.3 times
before the firm would be unable to cover its fixed financial
payments. Note: In the above equation, preferred dividends $2 per
share 500,000 shares outstanding.Fixed charge coverage with
EBITDA
Note: Since depreciation and amortization is a non-cash expense,
the firm actually has greater coverage of its interest expense and
preferred dividends.3.Fixed Charge Coverage EBIT/(Interest Expense
Preferred Dividends)Fixed Charge Coverage $40,000,000/($2,000,000
$500,000 ( $2)
$40,000,000/$3,000,000 13.3 times
Note: Some students might carry over the $5,500,000 in
depreciation and amortization from the prior problem. In which
case,Fixed Charge Coverage EBITDA/(Interest Expense Preferred
Dividends)Fixed Charge Coverage $45,500,000/(2,000,000 $500,000 (
$2)
$45,500,000/$3,000,000 15.17 times4.HPR (Current income Capital
gains)/Initial Investment(a)Here, Capital gains and dividends would
be taxed at 15%.The after-tax return is [(Dividends Capital
Gains)0.85]/Initial Investment
[((100$2) (100$5)) 0.85]/(100$25)
[$7000.85]/$2500 $595/$2,500 0.238 or 23.8%(b)Here, capital
gains is taxed at 15%, while the dividends are taxed at 25%.The
after-tax return is [(Dividends0.75 Capital
Gains0.85]/Investment
[(($2000.75) ($100$5) 0.85]/(100$25)[$150 425]/$2500 $575/$2,500
0.230 or 23.0%5.The issue here is the tax rate on common stock
dividends versus trust preferred stock dividends.
Common stock return $20.85 $1.70 after taxPreferred stock return
$2.40.67 $1.61 after tax.The common stock provides a higher
return.6.There is no set solution to this problem, since the answer
will vary with the preferred stock chosen by the student. Students
should be encouraged to get an actual quotation from the WSJ to
answer (a) and (b). Information relevant to answer (c), (d), and
(e) can be collected from Value Line Investment Survey or Standard
& Poors Stock Reports.
Here is one solution using Con Agras $1.25 preferred
stock.(a)Latest market price: $25.30(b)Dividend yield: $94%
($1.25/$25.30)(c)Dividend payment: $1.25/4 $0.3125(d)Fixed charge
coverage
(e)Book value (BV)
(f)$1.32 par value[Source for d, e, f: Con Agras 10-a filed
1/5/04]
The fixed charge coverage of BF Con Agras interest expense and
dividend payment is very strong. EBIT is almost three times the
needed amount. Since there is over seven times as much common stock
as preferred stock, the preferred stocks book value is quite high
relative to its par value.7.For Sar-Js preferred stock:
Price using the dividend valuation model from Chapter 8:
Both methods yield the same results: the first method uses the
perpetuity model for valuing the preferred stock. The second uses
the zero growth valuation model; when the growth rate is zero, it
becomes a perpetuity also. The required rate of return for
preferred stocks is the prevailing market yield.8.First, find the
future market price of the preferred if its yield falls to 6 %:
Now, find the expected realized yield according to the formula
in the chapter.Expected Realized Yield:Let r% be the expected
realized yield. We have75 7 PVIFAr%,2 yrs. 108 PVIFr%,2 yrs.Using
Tables, the realized yield can be calculated by trial and error.
Using a financial calculator, the realized yield 28.6%If the drop
in rates takes place in one year, the expected realized yield can
be calculated using the holding period return formula:
9.Conversion Equivalent Conversion ratioMarket price 21$40
$840.10.Common stock: $850/$25 34 sharesCommon stock profit ($35
$25) 34 shares $340Convertible profit (($50 (34 $35)) 850 $1240 850
$390Buy the convertible bond11.Convertible bond: $1,000 face value,
6% coupon, 20-year maturity, convertible into 20 shares; current
price of the convertible is $800, current stock price is
$35.(a)Current yield= Current income/Current price
= [(0.06)($1,000)]/$800 7.5%
(b)Conversion price Par value/Conversion ratio
$1,000/20 $50/share
(c)Conversion ratio Stated number of shares the bond can be
converted into
20 shares
(d)Conversion value Conversion ratio Market price of the
stock
20 $35 $700
Conversion parity=
$800/20 $40
(e)Conversion premium Current market price of convertible
Conversion value
$800 $700 $100
Conversion premium $100/$700 14.29%
(f)Payback Period
income fromincome from
convertible bondunderlying CS
2.2 years
(g)Yield to Maturity
Let r% be the yield-to-maturity. We have
800 60 ( PVIFAr%,20 yrs. 1,000 ( PVIFr%,20 yrs.
Using Tables, the realized yield can be calculated by trial and
error. Using a financial calculator, the realized yield 8.04%
(h)Investment value Value as a straight (nonconvertible)
bond
$60 PVIFA8%,20 yrs. $1,000 PVIF8%,20 yrs. $60 9.818 $1,000 0.215
$589.08 $215 $804.08
So the convertible is selling at its floor or at its value as a
bond.
12.Price of convertible in one year will be 10 percent over the
conversion value.Conversion value Price of stock Conversion
ratio
$75 20 $1,500Price of convertible $1,500 10% of $1,500 $1,500
$150 $1,650 (in 1 yr)Now, with $5,000 an investor can buy 5 bonds
priced at $1,000 each. Therefore:Interest (coupon) income ($1,000
0.08) 5
$80 per bond 5 $400Capital gains ($1,650 $1,000) 5
$650 per bond 5 $3,250Total income $400 $3,250 $3,6501 year
holding period return $3,650/$5,000 73%Given the convertible is
selling at a price of $1,000, which includes a 25% conversion
premium:Conversion value of the security $1,000/1.25 $800(A factor
of 1.25 is used in this formula since, with a 25% conversion
premium, the price of the convertible will be equal to 125% of the
conversion value.)
Note: This problem shows that, while the price of the
convertible went up by 65% over the course of the year (from $1,000
to $1,650), the price of the underlying common stock went up even
more: 87.5% (from $40 to $75). The reason for this, of course, is
the drop in the conversion premium (from 25% to 10%)i.e., this
represents lost profits, which act to reduce the rate of price
appreciation of the convertible issue (a point of which students
should be made well aware, since this major drawback is a common
feature of convertible securities).13.The investment value of a
convertible bond is done by pricing the bond at a rate equal (or
close) to the prevailing market yield for comparable nonconvertible
issues. In this case:Investment Value Interest income PVIFAk%,n
yrs. Maturity payment PVIFk%,n yrs.
$75 PVIFA9%,15 yrs. $1,000 PVIF9%,15 yrs.
$75 (8.061) $1,000(0.275) $879.5814.Conversion value Conversion
ratio Price of common stock
1.8 $40 $72Conversion premium Market price Conversion value
$90 $72 $18So there is a conversion premium of $18 or 25%
($18/$72).Conversion parity
Conversion parity is the price the common stock would have to
sell for in order to make the convertible security worth its
present market value. The difference between the conversion parity
and the actual market price of the common ($40) is the current
conversion premium per share of $10 ($50 $40) or 25%
($10/$40).(Solutions to Case ProblemsCase 12.1Penni Shows a
Preference for PreferredsThis case is designed to have the student
make decisions about preferred stocks. Both computations and
discussions about the investment merits of preferreds are
involved.(a)Pennis stockbroker expects the market yield to drop to
7 percent in two years.Price Dividend/Market Yield
$5.00/0.07 $71.43
Thus the price of the LaRamie preferred should rise from $48 to
about 71.50 in three years.(b)Expected Realized Yield:Let r% be the
expected realized yield. We have48 5 PVIFAr%,3 yrs. 71.50 PVIFr%,3
yrs.
Using Tables, the realized yield can be calculated by trial and
error. Using a financial calculator, the realized yield 23.4%
She stands to make $500/year in dividends for 3 years, plus
capital gains of $2,350 [($71.50 $48) 100 shares], for a total
profit of $3,850 (500 500 500 2,350)all from an investment of
$4,800 (or 100 shares of the preferred stock).(c)The realized yield
Ms. Jock can expect from this preferred stock is 35.3 percent. Her
alternative investment offers an annual rate of only 10 percent. If
the two alternatives have comparable risk exposure, the LaRamie
Mine $5 preferred is clearly the superior investment and therefore
she should seriously consider buying it.(d)While this may be a
quality preferred stock, the way it is being used (speculating on
interest rate movements) places the investor in a highly risky
position. It offers a very attractive rate of return. Even so, we
cannot lose sight of the fact that the security offers a high but
certainly not a guaranteed rate of return. So consideration of its
risks should be taken into account. If the market yield does not
fall to 7 percent, the price of the stock will not rise. Then the
yield will only be its 10.4 percent current yieldhowever, note that
this is still superior (albeit marginally) to her alternative
investment opportunity. If LaRamie has business losses, it may have
to pass its dividend in one or more quarters, causing the yield to
be even lower. Worse yet, if interest rates actually increase, the
market price of the stock will fall, rather than rise. This could
result in a low, or even negative, investment yield. (Remember,
however, this preferred has comparable risk with the alternative
investment, and it does have a higher expected return, so it is the
recommended choice. Students do need to be aware of the risks
involved, and this should be brought into the discussion.)Case
12.2Dave and Marlene Consider ConvertiblesThis case involves the
analysis of a convertible bond; it considers the merits of a
convertible as an equity-based investment, but also points out the
important role that the bond dimension plays in the valuation
process, particularly with regard to exposure to risk. In
discussing this case, the instructor should emphasize the
importance of analyzing the underlying common stock and formulating
interest rate expectationsafter all, its ultimately the stock and
bond dimensions of the convertible which gives the security its
value!! (Note, in the case, we assume Dave and/or Marlene have
already thoroughly analyzed the underlying common stock and
examined the current status/future direction of interest
rates.)(a)If we ignore conversion premium, the securities would be
priced at their conversion value (i.e., conversion ratio market
price of the stock); thus:(with the common at $66.67/share, the
convertible would be priced at:15 $66.67 $1,000.00(with the common
at $75/share, the convertible would be priced at:15 $75
$1,125.00(with the common at $100/share, the convertible would be
priced at:15 $100 $1,500.00With a 5% conversion premium, the
convertible would be priced at 105% of its respective conversion
value, as computed above; that is,(with the common at
$66.67/share:(15 $66.67) 1.05 $1,050.00(with the common at
$75/share:(15 $75) 1.05 $1,181.25(with the common at $100/share:(15
$100) 1.05 $1,575.00(b)Using the promised yield formula we haveLet
r% be the promised yield.800 75 PVIFAr%,20 yrs. 1,000 PVIFr%,20
yrs.Using Tables, the realized yield can be calculated by trial and
error. Using a financial calculator, the realized yield 9.82%(1)At
an 8% market rate, the bond value of the convertible is:Bond Value
Annual Interest Income PVIFA8%,18 yrs. 1,000 PVIF8%,18 yrs.
$75 9.372 1,000 0.250
$702.90 $250.00 $952.90At a 6% market rate, the bond value
is:Bond Value $75 PVIFA6%,18 yrs. $1,000 PVIF6%,18 yrs.
$75(10.828) $1,000(0.350)
$812.10 $350.00 $1,162.10(2)A drop in interest rates means that
regardless of what happens to the price of the underlying stock,
the price of the convertible will rise (in essence, the price floor
will rise as the convertible derives value from its bond
dimension). Note, for example, in the problem above that if
interest rates do fall to 6%, the price of the convertible will
increase from $800 (its present price) to $1,162and this is totally
independent of what happens to the price of the stock! And even if
interest rates only drop to 8%, the price of the convertible will
still go up (from $800 to $952). For this reason, a drop in rates
reduces the investors exposure to risk.(c)The minimum future
convertible price we calculated above is $1,000 (given there is no
conversion premium and the price of the common rises to
$66.67/share); therefore, the minimum expected yield would be:Let
r% be the promised yield.800 75 PVIFAr%,2 yrs. $1,000 PVIFr%,2
yrs.Using Tables, the realized yield can be calculated by trial and
error. Using a financial calculator, the realized yield 20.7%The
maximum future convertible price we calculated above is $1,500
(given the stock moves to $100/share); thus, maximum expected yield
would be:Let r% be the promised yield.800 75 PVIFAr%,2 yrs. $1,500
PVIFr%,2 yrs.Using Tables, the realized yield can be calculated by
trial and error. Using a financial calculator, the realized yield
45%(1)If the price of the stock drops to $40 and interest rates
drop to 9%, the convertible would trade as a bond and its price in
2 years would be:Bond Value $75 PVIFA9%, 18 yrs. $1,000 PVIF9%, 18
yrs.
$75 8.756 $1,000 0.212 $868.70(Note: at $40/share, the
conversion (stock) value of the security would be: 15 $40 $600,
which is considerably less than its bond value.)Let r% be the
promised yield.800 75 PVIFAr%,2 yrs. 868.70 PVIFr%,2 yrs.Using
Tables, the realized yield can be calculated by trial and error.
Using a financial calculator, the realized yield 13.4%Thus, even
under these conditions, the return is still fairly attractive.(2)If
the price of the stock drops to $40 and interest rates rise to 11%,
both the stock and the bond values of the security would drop; the
conversion value (per above) would be $600 and the bond value would
be:Bond Value $75 PVIFA11%,18 yrs. $1,000 PVIF11%,18 yrs.
$75 7.702 $1,000 0.153 $730.65As above, the convertible would
still trade as a bond, but this time there would be a capital loss
as the price of the convertible drops over the 2 year holding
period from $800 to $730.65. Under these conditions, the
convertible offers little investment appeal as it has a potential
expected yield of only 5.14%).Let r% be the expected yield.800 75
PVIFAr%,2 yrs. 730.65 PVIFr%,2 yrs.Using Tables, the realized yield
can be calculated by trial and error. Using a financial calculator,
the realized yield 5.14%(d)If Dave and Marlenes expectations are
right, this convertible could well offer the best of both worlds:
the chance to participate in capital gains via the equity kicker
and at reduced exposure to risk as the bond price floor increases
as well. As indicated above, the range of possible returns over the
next 2 years from this investment is excellent; i.e., 20.4% to 45%.
Of course, if things dont pan out, then the results may not turn
out so rosy after all. However, in this case, the biggest risk lies
in the future behavior of interest rates and even here, theyre
going to have to rise by about 160 basis points (from their current
level of 9.4% to 11%) before the investment turns sourrecall that
at 11%, the expected yield from the convertible is only 5.14%.
Thus, the investment in these med tech convertibles looks
attractive and is definitely one Dave and Marlene should seriously
consider.(Outside ProjectChapter 12What Makes Convertibles Tick?The
value of a convertible bond or convertible preferred is a function
of the outlook for the markets in fixed-income securities (bonds
and preferreds) and in common stocks. Therefore, anyone who invests
in convertibles must be familiar with interest rates/inflation
expectations, the outlook for the stock market, and the future
prospects of the underlying common stock. The purpose of this
project is to give you some insight into how convertibles change in
value relative to some of these variables.Go to the library and
obtain a copy of Barrons or The Wall Street Journal thats about a
year old, and from one of these sources, select two convertible
bonds and two convertible preferreds that are still traded today.
Once you have selected the securities, look up their conversion
featuresin something like Mergents or S&Pso that they can be
analyzed. In particular, calculate the following:1.Current
yield2.Conversion value3.Conversion party4.Conversion premium, in
dollars and percent5.Payback period6.Investment value of the
convertibles7.Dividend yield on the common stockCalculate these
measures for a year ago versus what they are today. (Note: Recall
that investment value at any time depends on the current market
rate that would apply to a nonconvertible fixed income security
with the same agency rating. You can find these rates in
publications like Mergents Bond Record or S&P Bond Guide.) In
addition, calculate the hold period return (over the one year
period of time used in your analysis) for each of the four
convertibles and their respective underlying common stocks.Now that
you have information for the last twelve months, describe what has
happened to the value of the convertible. How does the performance
of the convertible compare to whats happened in the bond market
over the past 12 months and to whats happened with the stocks?
Comment on your findings.
_1140262147.unknown
_1140272436.unknown
_1142239435.unknown
_1142239436.unknown
_1140272558.unknown
_1140274284.unknown
_1140274413.unknown
_1140272710.unknown
_1140272505.unknown
_1140262966.unknown
_1140263617.unknown
_1140265604.unknown
_1140272082.unknown
_1140263899.unknown
_1140263318.unknown
_1140262458.unknown
_1140261648.unknown
_1140261722.unknown
_1140261745.unknown
_1140261703.unknown
_1139905498.unknown
_1140261420.unknown
_1139901636.unknown
_1139902726.unknown
_1139901580.unknown