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Convertible Exchangeable Preferred Stock

  • Arnold R. Cowan

    (Iowa State University)

Convertible exchangeable preferred stock includes an option for the issuer to exchange the preferred for convertible bonds with identical pre-tax cash flows and conversion terms. In other respects this innovative corporate security is identical to traditional convertible preferred stock. The exchange feature provides the issuer with a potentially valuable option to swap a non-tax-deductible expense for a tax-deductible one. The exercise of the option imposes a cost on institutional investors, but even with the option fully priced, the innovative security should dominate the tradtional one as a capital raising vehicle. Thus, it is something of a puzzle that offerings of both security types persist for 15 years. I argue that firms expecting to force conversion quickly place a lower value on the tax shield obtainable by the exchange provision, and hence issue conventional convertible preferred to avoid pooling with lower-quality issuers. Thus, an offering of convertible exchangeable preferred stock should be a more negative signal than the traditional variety. Empirical evidence supports the hypothesis. The common stock price reactions to announcements of convertible exchangeable preferred stock average around –2% and are highly statistically significant. Reactions to convertible preferred stock announcements also are negative, but about half as large and less significant. Negative abnormal returns around the issuance date also are larger in the convertible exchangeable preferred sample. Cross- sectional regressions show that announcement and issuance abnormal returns depend on the use of the exchange option, whether the proceeds are used to refund existing convertibles, pre-offer financial leverage, growth opportunities and growth-related information asymmetry. Even firms with the most profitable growth opportunities experience negative abnormal returns around announcement and issuance, contradicting theories that predict positive information from equity- linked security offerings.

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Paper provided by EconWPA in its series Finance with number 9606001.

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Length: 50 pages
Date of creation: 06 Jun 1996
Date of revision: 12 Aug 1996
Handle: RePEc:wpa:wuwpfi:9606001
Note: Type of Document - Word 6; prepared on Windows 95; to print on Apple Personal Laser Writer NTR (Postscript); pages: 50; figures: none
Contact details of provider: Web page: http://128.118.178.162

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  1. Dierkens, Nathalie, 1991. "Information Asymmetry and Equity Issues," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(02), pages 181-199, June.
  2. Corrado, Charles J., 1989. "A nonparametric test for abnormal security-price performance in event studies," Journal of Financial Economics, Elsevier, vol. 23(2), pages 385-395, August.
  3. Denis, David J., 1994. "Investment Opportunities and the Market Reaction to Equity Offerings," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(02), pages 159-177, June.
  4. Kim, Yong O., 1990. "Informative Conversion Ratios: A Signalling Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(02), pages 229-243, June.
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  6. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
  7. Steven Raymar, 1993. "The Financing And Investment Of A Levered Firm Under Asymmetric Information," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 16(4), pages 321-336, December.
  8. Cowan, Arnold R. & Nayar, Nandkumar & Singh, Ajai K., 1990. "Stock Returns before and after Calls of Convertible Bonds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(04), pages 549-554, December.
  9. Cowan, Arnold R. & Sergeant, Anne M. A., 1996. "Trading frequency and event study test specification," Journal of Banking & Finance, Elsevier, vol. 20(10), pages 1731-1757, December.
  10. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
  11. Jeremy C. Stein, 1992. "Convertible Bonds as "Back Door" Equity Financing," NBER Working Papers 4028, National Bureau of Economic Research, Inc.
  12. Ambarish, Ramasastry & John, Kose & Williams, Joseph, 1987. " Efficient Signalling with Dividends and Investments," Journal of Finance, American Finance Association, vol. 42(2), pages 321-43, June.
  13. Karafiath, Imre, 1994. "On the Efficiency of Least Squares Regression with Security Abnormal Returns as the Dependent Variable," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(02), pages 279-300, June.
  14. Linn, Scott C. & Michael Pinegar, J., 1988. "The effect of issuing preferred stock on common and preferred stockholder wealth," Journal of Financial Economics, Elsevier, vol. 22(1), pages 155-184, October.
  15. Raymar, Steven, 1993. "The Financing and Investment of a Levered Firm under Asymmetric Information," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 16(4), pages 321-36, Winter.
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  17. Davidson, Wallace N. & Glascock, John L. & Schwarz, Thomas V., 1995. "Signaling with Convertible Debt," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(03), pages 425-440, September.
  18. Harris, Milton & Raviv, Artur, 1985. " A Sequential Signalling Model of Convertible Debt Call Policy," Journal of Finance, American Finance Association, vol. 40(5), pages 1263-81, December.
  19. James, Christopher, 1987. "Some evidence on the uniqueness of bank loans," Journal of Financial Economics, Elsevier, vol. 19(2), pages 217-235, December.
  20. Titman, Sheridan & Wessels, Roberto, 1988. " The Determinants of Capital Structure Choice," Journal of Finance, American Finance Association, vol. 43(1), pages 1-19, March.
  21. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  22. Arnold R. Cowan & Anne M.A. Sergeant, 1996. "Trading Frequency and Event Study Test Specification," Finance 9610002, EconWPA.
  23. Barber, Brad M. & Lyon, John D., 1996. "Detecting abnormal operating performance: The empirical power and specification of test statistics," Journal of Financial Economics, Elsevier, vol. 41(3), pages 359-399, July.
  24. Mikkelson, Wayne H. & Partch, M. Megan, 1986. "Valuation effects of security offerings and the issuance process," Journal of Financial Economics, Elsevier, vol. 15(1-2), pages 31-60.
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