When are Preferred Shares Preferred? Theory and Empirical Evidence

52 Pages Posted: 30 Apr 2004

See all articles by Vicente Pons-Sanz

Vicente Pons-Sanz

Yale School of Management

Shlomit Zuta

Tel Aviv University - The Leon Recanati Graduate School of Business Administration

Aharon R. Ofer

Northwestern University - Kellogg School of Management; Tel Aviv University - The Leon Recanati Graduate School of Business Administration

S. Abraham Ravid

Yeshiva University - Syms School of Business

Itzhak Venezia

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Date Written: April 2004

Abstract

This paper demonstrates that preferred stock may arise as an optimal security in a tax-induced equilibrium. This result is driven by graduated tax schedules and by uncertainty. In a more general sense, our results can be interpreted as a template for including any security with a different tax treatment in a firm's capital structure. The first part of the paper demonstrates that the Miller (1977) equilibrium framework can accommodate more than two securities if different investor classes are taxed differently on each security and the tax schedule for each investor group is upward sloping. We then simplify the tax schedule, but introduce uncertainty, which implies the possibility of bankruptcy and the possible loss of tax shelters. The interaction of tax rates and seniority now affects the contribution of each security to after-tax firm value, as in some states the firm may not be able to pay either interest (or dividends) or even principal to its various claimholders. It is shown why and how these features, i.e. the various tax rates and seniority, determine the financing equilibrium, which is obtained by equating the expected marginal tax benefit of all securities. We demonstrate that non-profitable firms will tend to issue preferred shares whereas profitable firms will not find preferred stock advantageous in our framework. Comparative statics with respect to various tax rates are derived as well. These predictions are tested using a large sample of firms for the last twenty-five years. The empirical testing broadly confirms the theoretical predictions.

JEL Classification: G32

Suggested Citation

Pons-Sanz, Vicente Pascual and Zuta, Shlomit D. and Ofer, Aharon R. and Ravid, S. Abraham and Venezia, Itzhak, When are Preferred Shares Preferred? Theory and Empirical Evidence (April 2004). Available at SSRN: https://ssrn.com/abstract=286782

Vicente Pascual Pons-Sanz (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Shlomit D. Zuta

Tel Aviv University - The Leon Recanati Graduate School of Business Administration ( email )

P.O. Box 39010
Ramat Aviv Tel Aviv 69972, 69978
Israel

Aharon R. Ofer

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-3562 (Phone)
847-491-5719 (Fax)

Tel Aviv University - The Leon Recanati Graduate School of Business Administration

P.O. Box 39010
Ramat Aviv Tel Aviv 69972, 69978
Israel

S. Abraham Ravid

Yeshiva University - Syms School of Business ( email )

United States

Itzhak Venezia

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

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