Hi I have a question : a. When convertible preferred shares are converted into common stock, the debt-to-equity ratio will drop ? Ans : I say it will drop because debt reamins same and equity increases as we dont have to pay preferred dividends any more ? Can somebody confirm !! Thanks
I don’t think convertible preferred shares fall in to the category of debt! They are a part of equity. Analysts can treat them as debt for certain purposes in valuing companies but if you look the preferred dividend is paid after adjusting tax whereas interest on debt is paid before adjusting tax. Moreover interest has to be paid by the company whereas if there are positive earnings the company is then required to pay dividends to preferred stock holders. While computing WACC debt, preferred stocks and common stocks are treated separately in terms of their weights and rate of returns. I think there wouldn’t be any effect on debt to equity ratios as the dollar amount of converting the preferred stocks would be equal irrespective of no. of shares they are converted in to. As if there would have been difference in their conversion than opportunity for arbitrage had occurred. I think convertible preferred shares are a part of equity and this is the reason they are written in the equity section of the balance sheet not in the liability section. I’m not aware of exceptional cases.
That’s right. Debt-to-equity remains the same when shares are converted. However if the company doesn’t pay dividends on its common shares (or they are lower than its preferred dividends), its D/E can be lower in the future.
Yes, I understand that they are part of equity … I guess im getting confused but what i mean is …when we dont pay preferred dividends …this increases our retained earnings and hence equity …and for this reason i am assuming the debt/equity ratio to drop ? Please correct me if i am wrong !!
DE will drop. But not immediately. After a several years of not paying preferred dividends the company will find its equity higher than if it had payed them (Once again – we assume that dividends on common shares are lower than preferred dividends). Conversion itself however does not change equity.
ahh …true …Thanks Deimon 