Question

Easy Company, a corporation, is considering a variety of equity financing methods. This company routinely pays dividends to its shareholders. It has the option to issue common stock, preferred stock, or a combination of the two.

Considering that equity financing requires that the stock offerings are attractive to investors:

• Compare and contrast the variety of preferred stock and the impact each has on the payment of dividends.
• Propose a stock offering portfolio that would be attractive to investors.
• Be sure to justify your proposal and include specific examples.

Answer 1

There are two types of preferred stocks: straight preferreds and convertible preferreds.

Straight preferreds are issued in perpetuity (although some are subject to call by the issuer, under certain conditions) and pay a stipulated dividend rate to the holder.

Convertible preferreds—in addition to the foregoing features of a straight preferred—contain a provision by which the holder may convert the preferred into the common stock of the company (or, sometimes, into the common stock of an affiliated company) under certain conditions (among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share or a certain price per share for the common stock).

Impact of these two types of preferred shares on payment of Dividends:

1. Preferred stock is a hybrid security that gives the shareholder a fixed dividend and a claim on assets if the company liquidates. In exchange, preferred shareholders don't have voting rights like common shareholder do.

Convertible preferred stock provides investors with an option to participate in common stock price appreciation.

2. Preferred shareholders receive an almost guaranteed dividend. However, dividends for preferred shareholders do not grow at the same rate as they do for common shareholders. In bad times, preferred shareholders are covered, but in good times, they do not benefit from increased dividends or share price. This is the trade-off. Convertible preferred stock provides a solution to this problem. In exchange for a typically lower dividend (compared to non-convertible preferred shares), convertible preferred stock gives shareholders the ability to participate in share price appreciation.

  Convertible preferred stock can be converted to common shares at the conversion ratio. The conversion ratio is set by the company before the preferred stock is issued. For example, one preferred stock may be converted into two, three, four, and so on, common shares. If the common shares rise, the preferred shareholder may opt to convert their shares into common stock, thus realizing an immediate profit. The price at which converting becomes profitable for the investor is called the conversion price.

Example of Convertible Preferred Stock

Convertible preferred shares priced at $100, with a conversion ratio of five, means that the common stock needs to trade above $20 in order for the conversion to be worthwhile for the investor. Even if the common stock is trading right near $20 it may not be worth it to convert since the preferred shareholder will be giving up their fixed dividend and higher claim on company assets.

As the common shares rise, it becomes more enticing to convert. If the common shares move to $25, the preferred shareholder gets $125 ($25 x 5) for each $100 preferred share. That's a gain of 25% if the investor converts and sells the common stock at $25.

The danger in converting is that the investor becomes a common shareholder, at the mercy of the swings in the stock price. If the price collapses to $15 after conversion, and the investor didn't sell at $25, they are worse off than they were before. They own $75 ($15 x 5) in common shares for each preferred stock (worth $100) they owned, and they no longer receive their fixed dividend or claim on assets.

Example of Straight Preferred Stock

A $25 par preferred share might set a $1.25 annual dividend or provide for a 5% of par payment that would also be $1.25 (5%x$25).