FINANCING CORPORATE MERGERS AND ACQUISITIONS WITH CONVERTIBLE PREFERRED STOCK*

Abstract

THE EXCHANGE OF SECURITIES in a merger is nontaxable to stockholders of the selling corporation only if the security received is common stock or convertible preferred stock with voting rights. Since 1960, preferred stock of this type has become increasingly popular in financing corporate mergers. The purpose of this study is to identify the reasons for this choice and to determine the financial impact, if any, on the subsequent earnings performance of firms financing mergers with convertible preferred stock. The basic hypothesis is that financing acquisitions with convertible preferred stock, instead of common stock, increases net earnings available to the residual owners of the acquiring firms. This hypothesis is tested by means of a five-year comparison of the actual earnings performance of firms employing convertible preferred stock in corporate mergers with earnings simulated as if common stock had been employed to finance the mergers. Data relate to thirty-three mergers financed with newly authorized issues of convertible preferred stock between January 1, 1960 and December 31, 1962. This study group includes all mergers where data were available when the acquiring firm was listed on the New York Stock Exchange. A control group of thirty-three similar mergers accomplished through an exchange of common stock is also employed. Four alternative common-stock valuation factors are considered: pre-merger earnings, cash dividends, market prices, and book values of the two constituent firms participating in each merger. Statistical tests confirm the findings of earlier studies that market prices and earnings were the primary determinants of actual exchange ratios. Accordingly, only these two factors are employed in simulating what the merger terms would have been if common-stock financing had been employed. A five-year comparison of the actual and simulated behavior of the study group yields the following results: simulated earnings per share are, on the average, slightly less than actual earnings, but the differences observed do not meet conventional standards of statistical significance. The earnings available to the residual owners of acquiring firms are higher (when compared with the returns that presumably would have resulted from a common-stock merger) for the majority of firms employing convertible preferred stock, but only slightly. The use of convertible preferred stock, instead of common stock, also increases incremental cash dividends associated with the mergers paid out by the acquiring firms. In addition, incomplete conversion of convertible preferred into common stock enables acquiring firms to save common stock when compared with direct common-stock financing of the study mergers. This trade-off between an increase in cash dividends and a savings in common shares outstanding, prevented the use of convertible preferred stock from substantially increasing net earnings available to the residual owners of acquiring firms during the five-year study period. Statistical analysis of the study group and control group indicates that firms merged with convertible preferred stock are considerably larger than their counterparts in