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 set when the conversion ratio is decided for a convertible security. 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).
Understanding Conversion Price
The conversion price comes into play when companies are trying to raise capital. They 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 doesn't 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 the conversion price.
The Importance of the Conversion Price
The conversion price is part of 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. The conversion price is set by management as part of the conversion ratio before the convertibles are issued to the public. The conversion ratio is the par value of the convertible security divided by the conversion price.
How to Calculate the Conversion Price
For example, a bond has a conversion ratio of 5, which means the investor can trade one bond for five shares of common stock. The conversion price of the convertible security is the price of the bond divided by the conversion ratio. If the bonds par value is $1000, the conversion price is calculated by dividing $1000 by 5, or $200. If the conversion ratio is 10, the conversion price drops to $100. So the market price has to catch up to the conversion price for the security to be converted. A higher conversion ratio results in a lower conversion price, just as a lower conversion ratio results in a higher conversion price.