A corporation issues $100 par convertible preferred stock, convertible at $10 pe

Question

A corporation issues $100 par convertible preferred stock, convertible at $10 per share, when the market price of the common is currently $5. The preferred is issued under an "anti-dilutive covenant." If the company declares a 25% stock dividend, which statements are TRUE? I The conversion price remains at $10 II The conversion price is adjusted to $8 III The conversion ratio remains at 10:1 IV The conversion ratio is adjusted to 12.5:1

The best answer is D. Under an "anti-dilutive" covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $10 per share. If there is a 25% stock dividend, the new conversion price will be adjusted to $10/1.25 = $8 per share. Since each preferred share is $100 par, the new conversion ratio will be $100/$8 = 12.5.

MY QUESTION IS : the new conversion price will be adjusted to $10/1.25 = $8. HOW DID THEY GET 1.25?

Explanation / Answer

When the company declares the stock dividend of 25%, then the number of shares of common stock get increased to 125% of total present number of shares of common stock before dividend. i.e. every common stock holder will become the owner of 1.25 shares for every 1 share held.

Similarly the number of shares of common stock to be issued to preferred stockholders also get increased to 125% of present number of common stock to be issued. i. e. one preferred stock will also get 1.25 shares for each share of common stock to be received on conversion. So conversion price $10 will become the price of 1. 25 shares. So, the conversion price will be reduced to 10/1.25 =$8.

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