Effect of Preferred Stock on Risk and Cost of Equity Capital - Evidence for Financially Distressed Firms

44 Pages Posted: 18 Jan 2011

See all articles by C.S. Agnes Cheng

C.S. Agnes Cheng

Hong Kong Polytechnic University - School of Accounting and Finance

Kenneth John Reichelt

Louisiana State University, Baton Rouge - Department of Accounting

Cathy Zishang Liu

affiliation not provided to SSRN

Date Written: January 12, 2011

Abstract

Preferred stock is a hybrid security that possesses features of debt and equity, but has been traditionally classified as equity under current accounting standards. Recent studies have shown that preferred stocks increases risk and cost of capital for common equity holders, hence, are more debt like. We use several different risk and cost of equity measures to show that preferred stocks are positively associated with risk and implied cost of equity capital. However, for financially distressed firms with high investment opportunity, preferred stocks tend to mitigate risks and behave more equity-like. We also find these risk-mitigation effects are stronger for non-redeemable preferred stocks. Our results have implications for standard setters in deciding on the classification of preferred stock and for managers and investors in assessing risks of a firm affected by preferred stocks.

Keywords: Preferred Stock, Financial Distress, Risk, Cost of Capital

JEL Classification: M41

Suggested Citation

Cheng, C.S. Agnes and Reichelt, Kenneth John and Liu, Cathy Zishang, Effect of Preferred Stock on Risk and Cost of Equity Capital - Evidence for Financially Distressed Firms (January 12, 2011). Available at SSRN: https://ssrn.com/abstract=1739222 or http://dx.doi.org/10.2139/ssrn.1739222

C.S. Agnes Cheng

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M715, Li Ka Shing Tower
Hung Hom, Kowloon, Kowloon
Hong Kong

Kenneth John Reichelt (Contact Author)

Louisiana State University, Baton Rouge - Department of Accounting ( email )

2821 Business Education Complex
Baton Rouge, LA 70803
United States
225-578-6233 (Phone)

Cathy Zishang Liu

affiliation not provided to SSRN

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