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Re: prokopton post# 50712

Wednesday, 01/30/2013 9:34:12 AM

Wednesday, January 30, 2013 9:34:12 AM

Post# of 80868
Come on people, I know it's early in the morning but if we can figure out what price Mr. Frost makes a profit at after he converts his preferred shares to common shares, we can go all-in and make good money here.

I know there's a lot brain power on this board. Let's put it to good use.

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Determining the Profit of Converting
The conversion ratio represents the number of common shares shareholders may receive for every convertible preferred share. The conversion ratio is set by management prior to issue, typically with guidance from an investment bank. For Acme, let's say the conversion ratio is 6.5, which allows investors to trade in the preferred shares for 6.5 shares of Acme stock.

The conversion ratio shows what price the common stock needs to be trading at in order for the shareholder of the preferred shares to make money on the conversion. This price, known as the conversion price, is equal to the purchase price of the preferred share, divided by the conversion ratio. So for Acme, the market conversion price is $15.38 ($100/6.5).

In other words, Acme common shares need to be trading above $15.38 for investors to gain from a conversion. If the shares do convert and drop below $15.38, the investors will suffer a capital loss on their $100-per-share investment. If common shares finish at $10, for instance, then convertible preferred shareholders' receive only $65 ($10 x 6.5) worth of common share in exchange for their $100 preferred shares. (The $100 represents the parity value of the preferred shares.)

SEE: Analyze Investments Quickly With Ratios

The Conversion Premium
Convertible preferred shares can be sold on the secondary market, and the market price and behavior is determined by the conversion premium, the difference between the parity value and the value of the preferred shares if the shares were converted. As we show above, the value of the converted preferred share is equal to the market price of common shares multiplied by the conversion ratio. Let's say Acme's stock currently trades at $12, which means the value of the preferred shares is $78 ($12 x 6.5). As you can see, this is well below the parity value. So, if Acme's stock is trading at $12, the conversion premium is 22% [($100 - $78)/100].

Read more: http://www.investopedia.com/articles/stocks/05/052705.asp#ixzz2JT9mFfHe

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An Example of Convertible Preferred Stock

Imagine you bought 100 shares of convertible preferred stock in XYZ bank. The preferred stock cost you $500 per share so your total investment is $50,000. This particular class of preferred stock pays $25 per share each year in dividends for a 5% dividend yield. It also has a special conversion privilege, which says that you can convert each share of preferred stock into 50 shares of common stock.

Think about that for a moment. Your preferred stock of $500 per share is paying you $25 per year in dividends, or a 5% yield. But you also get a lottery ticket that allows you to trade in your preferred stock and exchange it for 50 shares of common stock. That means your "cost" of converting to common is $10 per share ($500 preferred stock divided by 50 shares of common stock = $10 cost per share in the event of conversion).

If the common stock is less than $10, your convertible preferred rights aren't worth much. If the common stock is $10 or more, your conversion rights can be a goldmine. An illustration might help.
If you wake up and the common stock is $7, you wouldn't want to use your conversion privilege because you would exchange your 100 shares of preferred stock for 5,000 shares of common stock (since each share of preferred can be exchanged for 50 shares of common, or 100 preferred x 50 common = 5,000 common). That would leave you with 5,000 shares of common stock at $7 per share, or $35,000. That is a loss of $15,000, plus you wouldn't receive your preferred stock dividend, anymore!

Imagine, instead, the common stock skyrockets to $30 per share. You would take your 100 shares of preferred stock and convert them into 50 shares of common stock each for a total of 5,000 share of common stock. You could immediately sell your common stock for $150,000 because $30 per share market price x 5,000 shares = $150,000. Your cost was only $50,000 when you bought the convertible preferred, so you tripled your money and you collected dividends up until the time you exercised the conversion rights.