What is the 'Conversion Price'
The conversion price is the price per share at which a convertible security, such as corporate bonds or preferred shares, can be converted into common stock. The conversion price is calculated from the conversion ratio and determined when the convertible security is issued. The conversion ratio can be found in the bond indenture (in the case of convertible bonds) or in the security prospectus (in the case of convertible preferred shares).
BREAKING DOWN 'Conversion Price'Companies can raise capital through either debt or equity. Debt must be paid back to lenders, but it tends to cost less than equity due to the tax advantages associated with paying interest. Equity may cost more to raise than debt, but it does not need to be paid back. From the investor's perspective, bonds are safer, but they have a limited return. Equity provides an opportunity for share price appreciation, but no protection in case of company default. Convertible bonds, preferreds and debentures provide a hybrid option for companies and investors. Companies are willing to pay a little more, and investors are willing to accept a little less, for the embedded conversion option that allows holders of convertible securities to convert to common shares if the price of common shares reaches a certain price. This price is referred to as the conversion price.
The conversion price is essential in determining the number of shares to be received upon conversion. If shares never close above the conversion price, the convertible bond is never converted to common shares. Usually, the conversion price is set at a significant amount higher than the current price of the common stock to make conversion desirable only if a company's common shares experience a significant increase in value. To determine the conversion price, you need to obtain the conversion ratio. The conversion ratio is set by management before the convertibles are issued.
For example, a conversion ratio of 5 means the investor can trade one bond for five shares of common stock. The conversion price of the convertible securities is the price of one share of stock divided by the conversion ratio. If shares of company A are trading at $50, the conversion price is calculated by dividing $50 by 5, or $10. In other words, the convertible holder can exercise the option to convert to stock when the price hits $10. If the conversion ratio is 10, the conversion price drops to $5. A higher conversion ratio results in a lower conversion price, just as a lower conversion ratio results in a higher conversion price.