Response to the following problem:
The Tsetsekos Company was planning to finance an expansion in the summer of 2006. The principal executives of the company all agreed that an industrial company such as theirs should finance growth by means of common stock rather than by debt. However, they felt that the price of the company's common stock did not reflect its true worth, so they decided to sell a convertible security. They considered a convertible debenture but feared the burden of fixed interest charges if the common stock did not rise in price to make conversion attractive. They decided on an issue of convertible preferred stock, which would pay a dividend of $2.10 per share. The common stock was selling for $42 a share at the time. Management projected earnings for 2006 at $3 a share and expected a future growth rate of 10 percent a year in 2007 and beyond. It was agreed by the investment bankers and the management that the common stock would sell at 14 times earnings, the current price/earnings ratio.
a. What conversion price should be set by the issuer? The conversion ratio 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 (and also 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 make it a reasonable one.
b. Should the preferred stock include a call provision? Why?