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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.

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