Describe convertible preferred share features from the perspective of the preferred shareholders and the issuing firms. Preferred shares may provide for redemption by the issuing firm in the future. What types of redemption rights or obligations do redeemable preferred shares carry?

Answer 1

Convertible Feature

Convertible preferred shares give the holder of preferred shares the right (that is, the option)—but not the obligation—to convert the preferred shares into a specified number of common shares under certain specified conditions. Convertible preferred shares provide the security holders with a relatively assured dividend, a claim that is senior to that of common shareholders, and the possibility of capital appreciation by converting the preferred shares into common shares if the market price of the common shares rises sufficiently.

Because of the conversion option, changes in the market price of convertible preferred shares will often parallel changes in the market price of common shares. The issuing firm benefits from issuing convertible preferred shares, because these shares carry a lower dividend rate than purchasers otherwise would have required to buy the shares for a given price.

Redemption Right or Obligation

Preferred shares may provide for redemption by the issuing firm in the future. Redeemable preferred shares carry one of three types of redemption rights or obligations:

1 . Redemption Right of the Issuer

The issuing firm has the right (that is, the option)—but not the obligation—to redeem the preferred stock under certain conditions. Redeemable preferred stock is identical to callable preferred stock discussed above.

2 . Redemption Obligation of the Issuer at a Specified Time or upon a Specified Event Certain
to Occur

Common terminology refers to this preferred stock as mandatorily redeemable preferred stock. This preferred stock has attributes of both long-term debt and shareholders' equity. The specified redemption time is analogous to the maturity date of long-term debt. An example of an event certain to occur that would trigger redemption is the death of the preferred shareholder.

3 . Redemption Obligation of the Issuer Conditional on a Specified Event Not Certain to Occur

Some preferred stock is redeemable at the option of the holder; the owner of the
preferred stock has a put option, the right to require the issuing firm to repurchase the shares. This is an example of an event not certain to occur. The preferred shareholder may not demand redemption. The balance sheet classification of redeemable preferred stock depends on the provisions relating to redemption. U.S. GAAP and IFRS classify preferred stock subject to redemption only at the option of the issuing firm as shareholders' equity. Preferred stock subject to mandatory redemption is a liability. Preferred stock subject to redemption at the option of the preferred shareholders appears between liabilities and shareholders' equity in U.S. GAAP and as a liability in IFRS.