In the summer of 2018, the Gallatin Company was planning to financean expansion with a convertible security. It considered a convertible debenture but fearedthe burden of fixed interest charges if the common stock price did not rise enough to makeconversion attractive. The firm decided on an issue of convertible preferred stock, whichwould pay a dividend of $1.07 per share.The common stock was selling for $21 a share at the time. Management projected earningsfor 2018 at $1.40 a share and expected a future growth rate of 12% per year in 2019 andbeyond. The investment bankers and management agreed that the common stock wouldcontinue to sell at 15 times earnings, the current price/earnings ratio.a. What conversion price should the issuer set? The conversion rate will be 1.0; thatis, each share of convertible preferred can be converted into 1 share of common.Therefore, the convertible’s par value (as well as the issue price) will be equal to theconversion price, which in turn will be determined as a percentage over the currentmarket price of the common. Your answer will be a guess, but it should be a reasonableone.b. Should the preferred stock include a call provision? Why or why not?
In the summer of 2018, the Gallatin Company was planning to finance
an expansion with a convertible security. It considered a convertible debenture but feared
the burden of fixed interest charges if the common stock price did not rise enough to make
conversion attractive. The firm decided on an issue of convertible
would pay a dividend of $1.07 per share.
The common stock was selling for $21 a share at the time. Management projected earnings
for 2018 at $1.40 a share and expected a future growth rate of 12% per year in 2019 and
beyond. The investment bankers and management agreed that the common stock would
continue to sell at 15 times earnings, the current price/earnings ratio.
a. What conversion price should the issuer set? The conversion rate will be 1.0; that
is, each share of convertible preferred can be converted into 1 share of common.
Therefore, the convertible’s par value (as well as the issue price) will be equal to the
conversion price, which in turn will be determined as a percentage over the current
market price of the common. Your answer will be a guess, but it should be a reasonable
one.
b. Should the preferred stock include a call provision? Why or why not?
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