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

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