In the summer of 2021, the Gallatin Company was planning to finance an expansion with a convertible security. It considered a convertible debenture but feared the burden of fixed interest charges if the common stock price did not rise enough to make conversion attractive. The firm decided on an issue of convertible preferred stock, which would pay a dividend of $1.07 per share.

The common stock was selling for $21 a share at the time. Management projected earnings for 2021 at $1.40 a share and expected a future growth rate of 12% per year in 2022 and beyond. The investment bankers and management agreed that the common stock would continue to sell at 15 times earnings, the current price/earnings ratio.

a. What conversion price should the issuer set? The conversion rate will be 1.0; that is, each share of convertible preferred can be converted into 1 share of common.

Therefore, the convertible’s par value (as well as the issue price) will be equal to the conversion price, which in turn will be determined as a percentage over the current market price of the common. Your answer will be a guess, but it should be a reasonable one.

b. Should the preferred stock include a call provision? Why or why not?