A Simple Algorithm for the Valuation of Preferred Stock

Pradipkumar Ramanlal
Preferred stocks, hoth the straight variety as well as those that are callable and convertible, represent a significant source of corporate financing. Although several theoretical developments on preferred stock valuation have been around for some time, they are not amenable to straightforward calculation. This article provides an algorithm that makes accessible Mcrton's (1974) and IngersoU's (1977a) preferred stocks valuation formulas adapted for dividend paying common stock. The algorithm is simple and requires evaluation of algebraic expressions. It can be used by practitioners with access to programmable calculators and can be incorporated in the finance curricula of advanced students.

The value of preferred stock, as it is taughl in most finance courses, is simply the present value of a perpetuity, i.e.. the promised annual payment divided by the appropriate discount rate. While the method's simplicity is appealing, it provides no practical guidance to students and practitioners on how to determine the appropriate discount rate, thereby limiting the method's application. The technique that is often suggested to overcome this limitation is to use the implied discount rate of another preferred stock with similar default risk. This approach is reminiscent of the no-arbitrage method of bond pricing using the yield curve implied by prices of bonds with similar default risk. While the approach may eliminate arbitrage opportunities across securities with similar default risk, arbitrage opportunities across securities with different levels of default risk may nevertheless remain. Another method of valuing preferred stock is based on option-pricing theory. Treating the preferred stock (consol bond) as an option on the value of the underlying firm, Merton (1974) derived the differential equation for the preferred stock's price process accounting for default risk. He then solved the differential equation to obtain the preferred stock's valuation formula. Unfortunately, this formula is not readily useable because it is expressed in terms of the gamma and the incomplete
Pradipkumar Ramanlal is an AssLslanl Professor of Finance al the University of Souih Carolina, Columbia, SC 29208.

gamma functions, which are indeterminate integrals that must be evaluated by numerical methods. For the most part, such methods are not within the reach of either students or practitioners. The relative merits of the two methods for valuing preferred stocks, the traditional perpetuity model and the option-based model, are analyzed by Ferreira, Spivey. and Edwards (1992) for noncotnertihle issues. They find that the perpetuity model more accurately prices new issues of preferred securities while the option-based model more accurately prices seasoned issues. Thus the evidence is mixed. For convertible issues, the evidence is clearer. Firstly, while the optionbased model can be adapted to account for conversion features, the perpetuity model cannot (see Ingersoll, 1977a). And secondly, the pricing errors that Ferreira, Spivey, and Edwards (1992) find for nonconvertible preferred issues using the perpetuity model are larger than the pricing errors that Ramanlal, Mann, and Moore (1997) find for convertible issues using the optionbased model. Ramanlal, Mann, and Moore furthermore show that ignoring the conversion features will result in gross errors of model prices relative to market prices. Thus using the perpetuity model to price convertible issues cannot be advised. We propose that the optionbased pricing method be used in all cases except for new nonconvertible issues. This study provides a methodology that improves accessibility to Merton's (1974) pricing formula for nonconvertible preferred stocks. More importantly, the

11

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FINANCIAL PRACTICE AND EDUCATION SPRING / SUMMER 1997

methodology can be adapted to Ingersoll's (1977a) valuation results for callable and/or convertible preferred slocks. The methodology will be particularly useful to practitioners and advanced students of finance. For example, suppose a corporate treasurer considers raising capital by issuing, say, callable convertible preferred stock. How does the treasurer determine the offer price for the security? Equally important, how does an investment analyst in advising a client determine whether a seasoned preferred issue is fairly priced? The apparent choices available to the treasurer and the iinalyst are to either rely on an investment banker or determine the security's value by solving complex integrals using numerical techniques. The methodology proposed in this study provides an alternative which permits calculating preferred stock values using either a hand-held calculator or spreadsheet program.

(2) where P(a,z) =

ra

I. The Straight Preferred Stock's Valuation Formula

If the firm's value V follows a lognormal stochastic process and the preferred stock's aggregate value f is modeled as a contingent claim on the value ofthe firm, f(V), the straight-preferred stock's valuation function solves the ordinary differential equation (see Merton, 1974) +(rV-C)f(1)

with the lower-boundary condition f(0) = 0 and the upper-boundary condition f(o) = c/r. In Equation (1), the subscripts denote derivatives, o is the annualized standard deviation ofthe instantaneous return dV/V. r is the annual riskless rate, C is the aggregate annual cash flow to all equity claims including the preferred stock, and c is the aggregate annual cash flow to preferred stockholders.' The lower-boundary condition follows from the firm's limit liability. The upperboundary condition holds because if the firm's value increases without bound, the probability of default is remote and therefore the preferred stock becomes riskless. Accordingly, the preferred stock's value in that limit is simply a perpetuity with annual cash flows c discounted at the riskless rate r. The straightpreferred stock's valuation function Is-

In Equation (2), r(a) is the gamma function, the integral is the incomplete gamma function usually denoted by r(a,z), a = 2r/o' and d = C/rV. Following Ingersoll (1977a), the firm's value V is interpreted as the value of all equity securities (i.e., common stock and all convertible securities). The differential Equation (I) is derived under the assumption of no arbitrage and therefore holds regardless of the risk preferences of individuals in the economy. It follows that the solution ofthe differential equation, given by Equation (2), which is the straightpreferred stock's valuation function, also holds regardless of risk preferences. Note that Equation (2) is simply a perpetuity with annual cash flows c discounted at the riskless rate r, multiplied by the factor in brackets which accounts for the impact of default risk on price. The default risk influences the pricing function via the parameters a, d. It is reasonable to expect that the default risk will increase as the parameter a decreases, either because of a lower riskless rate r (which implies a lower growth rate for the firm),' or because of higher firm volatility G- (which increases the preferred stock's downside risk). It is also reasonable to expect that the default risk will increase as the parameter d increases. To see this, note that C/r is the upper bound on the present value of cash payments to all equityholders. If C/r is large relative to V, the likelihood that the firm can sustain such cash payments without facing potential financial distress is low, i.e., the likelihood of default increases as d increases.

II. Methodology to Obtain Approximate Preferred Stock Values

The valuation formula presented in Equation (2) would be simple to use if the P(a,z) term could be evaluated. To evaluate this term, one has to resort to either integration by numerical methods, lengthy tables ofthe gamma and incomplete gamma function, series approximation of the functions which have notoriously poor convergence properties, or the obscure method of continued fractions. These methods are neither simple nor convenient. To overcome these problems, we provide simple algebraic expressions that may be used to evaluate 'When the firm's value follows the stated lognormal process, the firtn's mean growth rate is r-o'/2.

'In contrast to Merton's (1974) original formulation for consol bonds as well as Ingersoll's (1977a) adaptation to convertible securities, our forniulalion permits dividend payments on the underlying common slock (i.e.. C # c). -The fact that Equation (2) solves Equation (1) can be shown by substituting the transformation l'CV) = (c/C)F(V) in (1) and using Merton's (1974) result that l/2a-V-F^^ + (rV - C)F^ - rF + C = 0 (see Ingersoll, 1977a, for details).

RAMANLAL A SIMPLE ALGORITHM FOR THE VALUATION OF PREFERRED STOCK

13

preferred stock values. For convenience, the straightpreferred stock's value is represented as follows: f(V) = (3)

provided; the first holds when the parameter a exceeds 1 and the second holds when the parameter a is less than 1: 7r(d) = a(d - 5) + P(d -

where n; is the default risk premium, i.e., the percentage premium above the riskless rate that compensates preferred stockholders for the default risk they bear. Equation (3) exactly equals Equation (2) if

where 5 < d< 1 and a > 1

(5a)

where 0 < d < 1 and a < 1

(5b)

In Equation (5a), the values of a, p. ri, and 6 depend on the parameter a, and 7r(d<6) is zero. These values To see this, substitute the expression for n given in are plotted in Exhibit 1 for a between 1 and 20. Notice Equation (4) into the denominator in Equation (3). Tbe that as the parameter a increases from 1 towards 20, a right-hand side of the resulting expression in (3) exactly is large while P andr] are small, then p becomes large equals the right-hand side of (2). Thus. Equations (3) while a andri remain small, and finally r\ becomes large and (4) together exactly represent Equation (2). Notice while a and p remain small. These suggest that as a that while the preferred stock valuation formula in (3) increases, 7E(d) is primarily linear in d, then quadratic, appears reminiscent of pricing that assumes risk and finally cubic. The value of 6 increases neutrality, this valuation formula actually holds monotonically as the parameter a increases. This regardless of the risk preferences of individuals in the implies that the default risk premium T C takes on positive economy because, as argued earlier. Equation (2) holds values that are significantly different from zero for regardless of preferences. larger and larger values of d (i.e., smaller and smaller In Equation (3), the value of preferred stock, f, values of V) as a increases (i.e., as the firm's volatility depends on the annual cash flows to preferred a^ decreases). In other words, as expected, the default stockholders, c, the riskless rate. r. and the default risk risk premium is small if the likelihood of default is low. premium, 7 U ; c and r are constants and therefore onlyn In Equation (5b), the values of a and P also depend needs to be evaluated according to Equation (4). In on the parameter a. These values are plotted in Exhibit general, evaluating 7i is difficult because it depends 2 for a between 1/2 and 1. As the parameter a decreases on P(,), which is an indeterminate integral (see from 1/2 towards I,a is large while P is small, and then Equation (2)). To overcome this problem, we provide p increases while a decreases. This suggests that as a an approximate algebraic expression for TT, which decreases, n(d) is primarily linear in d, taking on a we know from Equation (4) depends only on a = 2r/ square root dependence for smaller values of the o- and d = C/rV. parameter a. For our approximation ofjt to be of practical use, the To enable usage of these results to evaluate actual riskless rate r is assumed to vary between 0.06 and preferred stock prices, tabulated values are provided. O.I 2,''and the standard deviation of the firm's value is In Exhibit 3, a. p. r|, and 6 are provided for a range of assumed to vary between 0.11 and 0.50.^ Thus, the values of the parameter a between 1 and 20. These parameter a = 2r/a- ranges approximately from 0.50 to may be used with Equation (5a). Exhibit 4 provides a 20.0. The parameter d = C/rV is assumed to range from andp forvaluesof the parameter a between 1/2 and 1, 0 to 1. When d approaches 0, the firm's value V is large and these may be used with Equation (5b). If the value relative to the present value at the riskless rate of of the parameter a lies between, say, I and 1.2, linear cashflows to all equityholders C/r, thus the security is interpolation may be used to obtain corresponding essentially riskless. In contrast, when d approaches I, estimates for a, p. T|, and 5.'' V is approximately C/r, thus default on the preferred To illustrate how well the approximations for the stock or a reduction in common dividends is imminent. Two approximations for n in Equation (4) are ^Exhibits 3 and 4 are relatively compact, however. u.sage of
"This is reasonable if Ihe riskless rate is inlerpreied as the yield-Io-maturity of the 30-year US government bond. The average of monthly values of the annualized long-yield of US government bonds from 1988 to 1994 i.s 8.16% (Colenian. Fisher, and Ibbotson, 1995). 'These values imply that the value of the firm may vary by as little as 11% or as much as 50%i of its initial value over the period ol" one year. The average of the standard deviation of decile portfolios of New York Stock Exchange firms is 0.30 (Ibbotson Associates. 1995), our results is enhanced if algebraic expre.ssions for the dependence of a. p. r\. and 8 on the parameter a are available. Exhibits I and 2 show these dependencies are highly nonlinear is some cases, and therefore using the tabulated values is recommended. Nevertheless, we provide the following algebraic approximations that may be used instead (these are obtained by nonlinear curve fitting): For use with Equation (5a): a(a) =l/2a'. p(a) = (1.27/a)Expl-2.24a--"]. ii(a) = (0,23a'"-)Ln[0,4la"*''] +0,20a"". 5(a) = Max[O, -0.072 + 0.057a - 0.0014a-l. For use with Equation (5b): a(a) = 0-076 + 1.49a - 0.79a=, p(a) = 1.73 - 3..14a + 1.57a^

n=

(4)

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FINANCIAL PRACTICE AND EDUCATION SPRING / SUMMER 1997

Exhibit 1. Parameters a, p, TI, and 5 as Functions of a for Vaiues of a Between 1 and 20 (See Equation (5a))

0.6

0.4

0.2

20

Exhibit 2. Parameters a and p as Functions of a for Vaiues of a Between 1/2 and 1 (See
Equation (5b))

0.6

0.4

0.2

RAMANLAL A SIMPLE ALGORITHM FOR THE VALUATION OF PREFERRED STOCK

IS

Exhibit 3. Parameter Vaiues of the Defauit Risi< Premium 7i(d) in Equation (5a).
Values of a, p, r\, and 5 are provided for values of a between 1 and 20. ^ *'

a
I . O
1 . 2 1 . 4 1 . 6 1 . 8

a
0.5000 0.3220 0.2095 0.1380 0.0915 0.0605 0.0395 0.0252 0.0153 0.0084 0.0037 -0.0051 0.0848 0.2846 0.3869 0.4319 0.4459 0.4441 n.4335 0.4186 0.4020 0.3852 0.3683 0.2980

1 1 -0.0025 -0.0906 -0.1281 -0.1368 -0.1307 -O.I 180 -0.1019 -0.0844 -0.0669 -0.0498 -0.0329 0.0399

a
5 . 0
6 . 0 7 . 0 8 . 0 9 . 0 10.0 12.0 14.0 16.0 18.0 20.0

a
-0.0052 -0.0033 -0.0015 -0.0007 0.0025 0.0045 0.0072 0.0092 0.0114 0.0128 0.0144 0.2487 0.2131 0.1884 0.1676 0.1513 0.1362 0.1155 0.1015 0.0867 0.078 i 0.0683 0.0996 0.1518 0.1972 0.2421 0.2845 0.3282 0.4082 0.4841 0.5655 0.6400 0.7191

8
0.1857 0.2303 0.2692 0.3035 0.3338 0.3607 0.4066 0.4444 0.4762 0.5033 0.5269

o.oooo
0.0031 0.0069 0.0123 0.0194 0.0278 0.0371 0.0473 0.0579 0.0689 0.0800 0.1353

2 . 0
2 . 2 2 . 4 2 . 6 2 . 8 3.0 4.0

Exhibit 4. Parameter Values of the Default Risi< Premium 7E(d) in Equation (5b)
Values of a and p are provided for values of a between 1/2 and 1.

a
0.50 0.52 0.54 0.56 0.58 0.60 0.62 0.64 0.66 0.68 0.70 0.72 0.74

a
0.4630 0.4813 0.4978 0.5127 0.5261 0.5382 0.5491 0.5589 0.5678 0.5758 0.5831 0.5869 0.5954

P
0.4673 0.4239 0.3839 0.3469 0.3128 0.2811 0.2517 0.2244 0.1989 0.1751 0.1529 0.1321 0.1126

a
0.76 0.78 0.80 0.82 0.84 0.86 0.88 0.90 0.92 0.94 0.96 0.98 1.00

a
0.6006 0.6053 0.6095 0.6133 0.6166 0.6195 0.6221 0.6244 0.6263 0.6280 0.6293 0.6305 0.6315 0.0943 0.0771 0.0610 0.0457 0.0314 0.0179 0.005 1 -0.0069 -0.0183 -0.0291 -0.0393 -0.0489 -0.0581

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FINANCIAL PRACTICE AND EDUCATION SPRING / SUMMER 1997

Exhibit 5. The Defauit Risi< Premium (jc)

^ .

. ,

This exhibit shows exact values (using Equation (4)) and approximate values {using Equations (5a) and (5b)) for values of d between 0 and 1 and for a = 0.5,0.7, 1.0,4.0. and 15.0. The exact and approximate values are almost indistinguishable.

a=0.5
0.8

a=0.7
0.6

3
0.4

a = I.O

0.2

0.2

0.4

0.6

default risk premium Ji given by (5a) and {5b) fit the exact relation in Equation (4), Kid) is plotted in Exhibit 5 for values of d between 0 and I and for values of a equal to 0.5,0.7, 1.0,4.0, and 15.0, using both the exact and approximate relations. Each line in Exhibit 5 is actually a pair of lines {corresponding to exact and approximate values) that are almost indistinguishable. We conclude that Equations {5a) and (5b) provide a good approximation of Equation (4) for most practical purposes. Of course, the definitive test is how well the approximation works in yielding preferred stock prices. For this, we compare predictions from the exact pricing relation from Equation {2) with those from Equation (3), where n is given by the approximations presented in Equations (5a) and (5b). Both the exact and approximate pricing functions, f, are plotted in Exhibit 6 for values of d between 0 and 1 and for values of a equal to 0.5,0.7, 1.0,4.0, and 15.0. We take the annual cash flow to preferred stockholders to be c = 10 and the riskless rate to be r = 0.05. thus the value of the preferred stock with zero default risk is c/r = 200. In Exhibit 6, all valuation functions equal 200 when d equals 0 because the default risk at this point is indeed zero. Again, each line in Exhibit 6 is actually a pair of lines (corresponding to exact and approximate values) that are almost indistinguishable. We conclude that Equation (3) together with Equations (5a) and (5b) provide a good approximation of the exact preferred stock valuation formula given in Equation (2).

III. Adaptations to Convertible Preferred Stock

We now show how the approximate valuation function for straight preferred stock given in Equations (3), (5a). and (5b) may also be used to value convertible preferred stock. Both the callable and noncallable types of preferred stock are examined. The aim is to show that knowing how to value the straight issue, f(V), is sufficient to value convertible issues.

A. Noncallable Convertible Preferred Stock

Eor a noncallable preferred stock that is convertible into a fixed proportion 7 of the firm's value V, the valuation function, denoted by g(V), satisfies Equation (1) but with the new upper-boundary condition g^(<) = 7 . This boundary condition arises from the optimal exercise of the preferred stock's conversion option (see Brennan and Schwartz, 1977). The convertible-preferred stock's valuation function
IS'

(6)

''The fact that Equation (6) solves (1) can be shown by direct subsiiiution and u.sing the result Ihat f(V) solves Equation (1). The new boundary condition can be shown to hold by noting that t\,(>) = 0. The latter equality holds because f(V) approaches the con.stant value c/r as V approaches infinity.

RAMANLAL A SIMPLE ALGORITHM FOR THE VALUATION OF PREFERRED STOCK

17

Exhibit 6. The Vaiue of Preferred Stocic (f)

This exhibit shows exact values (using Equation {2)) and approximate values (using Equations (3), (5a), and (5b)) for values of d between 0 and 1 and for a = 0.5,0.7,1.0,4.0, and 15.0. The exact and approximate values are almost indistinguishable.
200

180

160

140

120

0.2

0.4

The two terms on the right-hand side of Equation (6) are simply the components of the convertible preferred stock's worth in terms of its straight value, f(V). and the value of its conversion option, 7(V Cf{V)/c). The conversion option vaiue is amenable lo a simple interpretation. Cf(V)/c is simply the present value of cash flows, incorporating default risk, to all equityholders including the preferred issue. Thus. (V - Cf{V)/c) can be interpreted as the remaining firm value to which preferred stockholders have the proportionate claim 7. i.e.,7(V - Cf(V)/c). This result simply states that preferred stockholders are not protected against equity dilution arising from dividend payments to other equityholders including common shareholders."

exercise of the preferred's call and conversion options assuming perfect capital markets (see Ingersoll. 1977a).^ The corresponding valuation function is"' h(V) = g(V) f{V) (7)

B. Caiiabie Convertible Preferred Stock

For a callable, convertible preferred stock that is convertible into a fixed proportion7 of the firm's value and callable with fixed call price K, the valuation function, denoted by h{V), satisfies Equation (1) but with the new upper-boundary condition h(V=K/7) = 7V. This boundary condition arises from the optimal
"II is interesting to note (see Equation (6)) that when cash flows to preferred stockholders is less than what they wouid receive if they had converted their securities (i.e., c < yC), the market value of the preferred siock is less than its conversion value {i.e., g{V) < yV). Under these conditions, il is better for preferred stockholders to convert. (See Constantinides and Grundy. 19B7, for discussions on ihis topic.)

V^ = K/7 is the firm's value when the preferred stock is called. The two terms on tiie right-hand side of Equation (7) are the components of the callable preferred stock's worth in terms of its noncallable counterpart's value, g(V), and the vaiue of the firm's call option, A '(c/C - 7)(V - Cf(V)/c). It can be shown
"The preferred stock should be called when the firm's value increases such that the conversion value equals the call price {i.e., y\ - K); preferred stockholders convert at Ihat point and so the preferred stock's value just prior equals its conversion value {i.e., h(V= y/ic) = yV). While early studies of calls of convertible securities found deviations from this optimal behavior (see. e.g., Ingersoll, 1977b, and Mikkelson. 1985), more recent work finds either insignificiint violations {Asquith, 199.'i) or that !he violalions are such ihal the stated upper-boundary condition holds nevertheless {Byrd, Mann, Moore, and Ramanlal. 1997). '"Il is straightforward lo show that Equation {7) solves {I) by direct substitution and using the result that g{V) solves (I). The new upper-houndary condition can be verified by selling V - K/y in Equation (7).

18

FINANCrAL PRACTICE AND EDUCATION SPRING / SUMMER 1997

that the firm's option to call the preferred stock lowers its market value relative to an otherwise identical noncallable issue.

B. Input Values for the Valuation Function

Aggregate value of preferred stock (h{P )): PN=5P p p p Value of all equity securities (V(P )):'^ P N + P N =2000 + 5P
c c p p p

C. Comparison of Callable and Noncallable Issues

Rewriting the expression for h(V) in Equation (7) by substituting the expression for g(V) given in Equation (6) yields an interesting result: (8) where

Aggregate dividends to all equityholders (C): DN + D N =105

t 1 ; p p

Aggregate dividends on preferred issue (c): DN =25 p p Call price (K): Conversion ratio (y): CONV(Np/(CONV(Np + NJ) = 0.1071 Annualized riskless rate (r): '^ 8.16% Annualized standard deviation of dV/V (o) 30.12%

Equation (8) suggests that a callable preferred stock with conversion ratio 7 can be thought of as a noncallable preferred stock with a smaller effective conversion ratiov ' {compare Equations (6) and (8)).

C. Parameter Values Required for Valuation

The parameter a: = 1.8 The parameter d(Pp): p C/rV = 1286/(2000 + 5Pp) Firm's value when call is announced (V^): Coefficient a:'" Coefficient p: Coefficient Tl: The parameters: Effective conversion ratio (7'):" 0.0915 0.4457 -0.1307 0.0194 0.0699

IV. Numerical Example

A numerical example for a callable and convertible preferred issue will illustrate how the previous results may be used in practice. Several parameters values must be specified. To ensure that the illustration is representative, parameter values based on actual market data obtained from Ibbotson Associates (1995) and Coleman, Fisher, and Ibbotson (1995) are used. A. Raw Data Number of common shares outstanding (N ):" 50 million shares Market price of common stock (P^): $40 per share Annual common dividend (D ): $1.60 per share Number of preferred shares outstanding (N ); 5 million shares Price of preferred stock (P,): dollars per share {to be determined) Annual preferred dividend {D ): $5.00 per share Nominal call price {CALL):'^ 120 Nominal conversion ratio {CONV): 1.2 common per preferred converted

The numerical values in sections B and C above are used to set up the valuation function (8): 5P = (9)

In Equation {9), V(P ) is defined in Section B {item 2), d{P ) is defined in Section C {item 2), and K(d) is given by Equation {5a). It is straightforward to solve Equation {9} iteratively for P using either spreadsheet software or a programmable calculator. An initial value
"Assuming there are no other convertible preferred stock, convertible debt or warrants outstanding. 'The yield-to-maturity of the US government long bond is taken as the riskless rate. These rates are provided by Coleman, Fisher, and Ibbotson (1995), For the illustration, the average of these monthly values from 1988 to 1994 is used. '^This can be estimated using tbe sample variance of log(Vy V^ i) using daily data for V^ available in tbe NYSE Daily Stock Price Record and then annualizing this variance. For the variance calculation, the market price of the preferred issue may be used to evaluate V^. For the example at hand, the average of the standard deviation of decile portfolios of NYSE firms obtained from Ibbotson Associates (1995) is used. "The four parameters a, p, r). 8 are from Table I for a = 1.8. "The effective conversion ratio is defined following Equation (8). It is evaluated using the parameter after Equation (7). Equation (3), and Equation {5a).

"The number of shares outstanding, the market price, and annual dividends for common and preferred slocks are obtainable from the NYSE Daily Stock Price Record, "The nominal call price and conversion ratio are obtainable from Moody's manuals.

RAMANLAL A SIMPLE ALGORITHM FOR THE VALUATION OF PREFERRED STOCK

19

for P^, say, P^" = {c/r)/N^ = $61.24 {i.e., the per share present value of cash flows to the preferred issue discounted at the riskless rate), is substituted on the right-hand side of Equation (9). The first iteration yields P ' = $69.69, and substituting this back into the rigbt-hand side of {9) for Pp yields the second iterated value P - = $70.34. The third iteration yields $70.3989 while an infinite many more yields $70.4048. The exact value for P obtained by evaluating the gamma and incomplete gamma functions is $70.3866. Thus, the suggested numerical procedure has desirable properties of simplicity and rapid convergance to a result that is very close to the exact value. The component values of the callable, convertible preferred stock in terms of its straight value and the value of its call and conversion options are straightforward to obtain.

V. Conclusion
To help bridge financial theory and practice, this

study develops an algorithm that practitioners, including corporate treasurers and financial analysts, will find useful when calculating the value of preferred stocks, both the straight variety and the callable convertible type. Using a hand-held calculator, corporate treasurers will be able to determine the offer price of preferred issues when making capital financing decisions. Moreover, financial analysts will be able to advise tbeir clients whether such issues are fairly priced in the secondary market. The proposed valuation algorithm makes the theoretical pricing results of Merton (1974) and Ingersoll {1977a) available to practitioners by removing the need to evaluate complex integrals numerically. Only algebraic expressions must be evaluated. The study also provides some intuition on what influences the preferred stock's call and conversion option values and how these option values may be determined.

References
Asquitb, Paul. 1995, "Convertible Bonds are not Called Late," Journal of Finance 50 (No. 4. September). 1275-1290. Brennan, Michael J. and Eduardo Schwartz, 1977, "Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion," Journal of Finance 32 (No- 5. December), 1699-1715. Byrd, Anthony K., Steven V. Mann. William T. Moore, and Pradipkumar Ramanlal. 1997, "Rational Timing of Calls of Convertible Preferred Stock." University of Soutb Carolina Working Paper. Coleman, Thomas S.. Lawrence Fisber. and Roger G. Ibbotson, 1995. U.S- Treasury Yield Curves J926-i994. New York, NY, Moody's Investors Service, Inc. Constantinides, George M. and Bruce Grundy, 1987, "Call and Conversion of Corporate Bonds: Theory and Evidence," tJniversity of Chicago Working Paper. Ferreira, Eurico. J., Michael F. Spivey, and Charles E. Edwards, 1992, "Pricing New-Issue and Seasoned Preferred Stocks." Financial Management 21 (No. 2, Summer), 52-62. Ibbotson Associates. 1995, Stocks. Bonds. Bills, and Inflation 1995 Yearbook. Cbicago. IL. Ibbotson Associates, Ingersoll, Jonathan, 1977a. "A Contingent-Claims Valuation of Convertible Securities." Journal of Financial Economics 4 (No. 3, May), 289-322. Ingersoll, Jonathan. 1977b. "An Examination of Corporate Call Policies on Convertible Securities," Journal of Finance 32 (No. 2. May), 463-478. Merton. Robert. 1974. 'On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance 29 (No. 2. May). 449-470. Mikkelson. Wayne H,, 1985. "Capital Structure Changes and Decrease.s in Stockholders' Wealth: A Cross-Sectional Study of Convertible Security Calls." in B. M. Friedman. Ed., Corporate Capita! Structure in the United Slates, Chicago, IL. University of Chicago Press for National Bureau of Economic Research. Ramanlal, Pradipkumar. Sleven V. Mann, and William T. Moore, 1997, "Convertible Preferred Stock Valuation: Tests of Alternative Models," Journal of Quantitative Finance and Accounting (forthcoming).