Investors' Assessment of the Dilution and Solvency Effects of Hybrid Instruments

Abstract

The current financial reporting model requires dichotomous classification of financial claims as either liabilities or equity. Classifying financial claims is challenging when instruments have attributes of both liabilities and equity (i.e., hybrid instruments). In this study, we examine under what conditions that common equity investors assess one class of hybrid instruments – preferred stock – similar to liabilities or equity. Preferred stock is similar to liabilities because it is senior to common equity and thus reduces the claims of common shareholders on the net assets of the firm (a dilution perspective). Preferred stock also is similar to equity because it cannot cause insolvency (a solvency perspective). We extend capital structure theory to identify entity-level economic characteristics important to determining when the dilution or solvency perspective is most consistent with investors’ assessments of preferred stock. We predict and find that investors assess preferred stock similar to liabilities when expected financial distress costs are low. We predict and find that investors assess preferred stock similar to equity when expected financial distress costs are high. Further, our results indicate that investors do not assess preferred stock instruments consistent with current U.S. GAAP classifications that are based on instruments’ contractual provisions.

Keywords: Hybrid Instrument, Classification, Capital Structure Theory, Liabilities Versus Equity

JEL Classification: M41, G14, G32, G33