Why Do Companies Convert to Common Stock?
Companies can raise money by selling common stock, preferred stock, and bonds in the financial markets. Common stock is the most risky to the investor, but it has the greatest potential to rise in value. For this reason, companies sometimes offer convertible bonds or convertible preferred stock to investors. That way, the investor can buy a stable investment but can convert it to common stock if the stock price were to take off.
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Balancing Equity and Debt
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The main reason that companies go public is so they have access to the equity market. They can raise large sums of money this way by issuing stock. However, if the company issues too much stock, the shares of the outstanding stock can decline. This is one reason it is good for the company to have some long-term debt in the form of bonds. Investors study the amounts of equity and debt on the company's books to help determine the value of the company.
Inducing Investors to Buy Bonds and Preferred Shares
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Investors may want the security of a bond or preferred stock, but also a share of the fortunes of the company if the stock price rises. For them, there are convertible bonds and convertible preferred stock. These can be exchanged for a set amount of stock if the investor desires at any time. This is a one-way transaction: the common stock cannot then be converted back into its original form.
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Issuing Too Many Bonds Can Be Risky
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Issuing too many bonds can be problematic as well. If a company cannot pay the interest on the bonds, the firm goes into bankruptcy, and the bondholders take over the company. Sometimes a company facing bankruptcy can convince bondholders to convert their bonds into stock, but the bondholders must all agree to this plan. General Motors attempted this before it fell into bankruptcy in 2009.
In this sense, selling stock is less risky to the issuer, because the company won't go into bankruptcy if it misses a dividend payment.
Preferred Stock Is Less Risky to the Company Than Bonds
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An alternative to bonds is preferred stock, which offers the steady returns of a bond but won't force the company into bankruptcy if it misses a dividend payment. However, the dividends for preferred shareholders must be paid eventually, before any dividends are paid to the common stock investors. In addition, if the company goes bankrupt, the preferred stock shareholders recoup their investment out of the remaining assets of the company before the common stock shareholders do.
Diluted Earnings Per Share
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Earnings Per Share (EPS) is the ratio most frequently used by investors to compare stocks within the same industry. By issuing more stock through the conversion of bonds or convertible preferred stock, EPS decreases, making the corporation less attractive to investors.
A problem arises when an investor tries to value a company that has issued convertible bonds or convertible preferred stock that have not yet been converted. For this reason, accountants declare not only about the number of shares outstanding, but also the "diluted shares outstanding" to represent the amount of outstanding stock that may exist in the future.
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