Definition
Conversion Price is the dollar value at which convertible securities, such as bonds, debentures, or preferred stock, can be converted into common stock. This price is announced at the time the convertible security is initially issued. The conversion price is a key term in the investment’s prospectus, guiding investors in understanding how and when their convertible securities can be turned into equity.
Examples
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Example 1: Consider a convertible bond with a face value of $1,000 and a conversion price of $50 per share. An investor holding the bond can convert it into 20 shares of the company’s common stock ($1,000 / $50 = 20 shares).
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Example 2: Suppose a firm issues convertible preferred stock at $100 per share with a conversion price of $25. An investor can convert one share of preferred stock into four shares of common stock ($100 / $25 = 4 shares).
Frequently Asked Questions
Q1: Why is the conversion price important for investors?
- A1: The conversion price is crucial because it determines the number of shares an investor will receive when converting their bonds or preferred stock into common stock. It directly impacts the potential profit from the conversion.
Q2: How is the conversion price set?
- A2: The conversion price is typically set by the issuing company at a premium to the current market price of the common stock at the issuance time. This premium compensates for the bondholder’s conversion option.
Q3: Can the conversion price change after the issuance?
- A3: Generally, the conversion price is fixed at issuance. However, it can be adjusted under specific conditions such as stock splits, stock dividends, or other corporate actions.
Q4: What is the difference between conversion price and conversion ratio?
- A4: The conversion price refers to the price at which the bond or preferred stock can be converted into common stock, while the conversion ratio indicates the number of common shares that can be obtained upon conversion of one unit of convertible security.
Q5: What happens if the market price of the common stock is below the conversion price?
- A5: If the market price is below the conversion price, converting the security would not be beneficial for the investor because the value of the converted shares would be less than the value of the convertible security.
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Convertible Bond: A type of bond that can be converted into a predetermined number of shares of the issuing company’s common stock.
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Debenture: A type of debt instrument that is not secured by physical assets or collateral but is supported by the creditworthiness and reputation of the issuer.
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Preferred Stock: A class of ownership in a corporation with a higher claim on assets and earnings than common stock, often with fixed dividends.
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Prospectus: A legal document required by and filed with the Securities and Exchange Commission (SEC) that provides details about an investment offering for sale to the public.
Online References
- Investopedia: Conversion Price
- SEC: Convertible Securities
- Corporate Finance Institute: Convertible Bonds
Suggested Books for Further Studies
- “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran
- “The Handbook of Convertible Bonds: Pricing, Strategies and Risk Management” by Jan De Spiegeleer and Wim Schoutens
- “Convertible Securities: Corporate Debt Securities - Financial Proposal of Revenue” by Fred Henry Rayfield
Fundamentals of Conversion Price: Finance Basics Quiz
### What is the primary purpose of a conversion price?
- [ ] To determine the interest rate of a bond.
- [x] To set the value at which a convertible security can be exchanged for common stock.
- [ ] To measure the maturity duration of debt.
- [ ] To assess the credit quality of the issuer.
> **Explanation:** The conversion price sets the dollar value at which a convertible security, such as a bond or preferred stock, can be converted into common stock.
### What is the result when an investor converts a convertible bond to common stock at the conversion price?
- [x] The investor receives a specified number of common shares.
- [ ] The investor gets the face value of the bond in cash.
- [ ] The investor gains additional interest payments.
- [ ] The investor gets preferred stock instead of common stock.
> **Explanation:** When an investor converts a convertible bond, they receive common shares based on the conversion ratio determined by the conversion price.
### Why might an investor choose to convert their bonds to stock?
- [ ] To increase the bond's interest rate.
- [x] To benefit from the appreciation of the stock price.
- [ ] To lower the company’s debt obligations.
- [ ] To gain preferential treatment over common shareholders.
> **Explanation:** Investors might convert their bonds to stock to benefit from the potential appreciation in the stock's market value.
### What condition usually must be met before conversion becomes attractive?
- [ ] All bonds must mature.
- [ ] The company must issue new stocks.
- [x] The market price of the stock must exceed the conversion price.
- [ ] The company must announce dividends.
> **Explanation:** The conversion becomes attractive when the market price of the stock exceeds the conversion price, making the conversion economically favorable for the investor.
### Convertible preferred stock typically offers what feature?
- [ ] Variable interest rates.
- [ ] Superior voting rights.
- [ ] Guaranteed conversion.
- [x] Fixed dividends and the option to convert to common stock.
> **Explanation:** Convertible preferred stock typically comes with fixed dividends and the option to convert into common stock at the predetermined conversion price.
### If a convertible bond has a face value of $1,000 and a conversion price of $50, how many shares can the bond be converted into?
- [ ] 10 shares
- [ ] 15 shares
- [x] 20 shares
- [ ] 25 shares
> **Explanation:** The bond can be converted into 20 shares ($1,000 / $50 = 20 shares).
### What would discourage an investor from converting a convertible security?
- [ ] Dividend payments.
- [ ] Falling bond interest rates.
- [x] Market stock price lower than the conversion price.
- [ ] High company profitability.
> **Explanation:** An investor would be discouraged from converting if the market stock price is lower than the conversion price, as it would result in a financial loss upon conversion.
### How does a stock split affect the conversion price?
- [x] The conversion price generally decreases.
- [ ] The conversion price increases.
- [ ] No impact unless specified.
- [ ] The bond's face value is adjusted rather than the conversion price.
> **Explanation:** In the event of a stock split, the conversion price generally decreases to ensure that bondholders receive an equivalent number of shares.
### Can the conversion price be adjusted after issuance?
- [ ] No, it remains fixed.
- [x] Yes, in cases like stock splits or dividends.
- [ ] Only during mergers.
- [ ] Only if the investors agree.
> **Explanation:** The conversion price can be adjusted for specific actions like stock splits, dividends, or other corporate actions to maintain fairness for the bondholders.
### Why might companies issue convertible securities?
- [ ] To decrease their stock price.
- [ ] To avoid paying dividends.
- [x] To raise capital with the option to convert to equity.
- [ ] To increase their long-term debt.
> **Explanation:** Companies issue convertible securities to raise capital with the option for investors to convert their investment into equity, which can be advantageous if the company's stock price rises.
Thank you for exploring the fundamental aspects of Conversion Price in the financial realm. Continue expanding your knowledge and analytical skills to excel in your financial pursuits!
