Download This PaperInvestors' Assessment of the Dilution and Solvency Effects of Preferred Stock Instruments
Journal of Business Finance & Accounting, 0[10.1111/jbfa.70061]
54 Pages Posted: 7 May 2020 Last revised: 20 Apr 2026
Date Written: January 14, 2026
Abstract
GAAP requires dichotomous classification of financial claims as liabilities or equity, yet classification becomes challenging when instruments have attributes of both (i.e., hybrid instruments). We examine conditions under which common shareholders assess one class of hybrid instrument –– preferred stock –– as similar to liabilities or equity. Preferred stock is similar to liabilities because it is senior to common; thus, payments to preferred reduce net assets available to common, decreasing their expected cash flows (dilution perspective). It is similar to equity because payments to preferred cannot cause bankruptcy; thereby, having no obligatory effect on cash flows to common (solvency perspective). We identify expected financial distress costs as the entity-level characteristic that distinguish when each perspective is more important to common. We predict and generally find that common shareholders change assessments of preferred stock from negative to zero as expected financial distress costs change from low to high. For high expected financial distress cost firms, we also identify two situations that suggest increased expected cash flows from preferred to common for firms (1) issuing additional preferred (which reduces expected financial distress costs) and (2) one year prior to delisting (due to expected violation of strict bankruptcy claims’ priority). Standard-setting implications are discussed.
Keywords: preferred stock, balance sheet classification, capital structure theory, dilution versus solvency; liabilities versus equity
JEL Classification: M41, G32, M48
Suggested Citation: Suggested Citation
Catherine Shakespeare
University of Michigan - Stephen M. Ross School of Business ( email )
701 Tappan Street
Ann Arbor, MI MI 48109
United States