The Effect of Common‐Stock Dividend Reductions on the Returns of Nonconvertible Preferred Stocks: A Note

Abstract

THIS NOTE REPORTS THE price responses of nonconvertible preferred securities and their common stocks to the announcement of a reduction in the firm's common-stock dividend. We find that both preferred and common-share prices tend to fall in the event month, while the preferred stocks show further evidence of price declines in the following month. However, this lagged response is primarily due to those preferred issues with limited trading activity. I. Research Design The event investigated is the announcement of a reduction in a firm's commonstock dividend. A is defined as a reduction in the annual dividend from its former level. The elimination of an extra dividend is not considered to be a dividend cut. Prior studies have shown that a dividend cut has a strong negative effect on the price of common stocks.' However, its impact on the price of a firm's preferred stock may be quite different. According to the information-content-of-dividends hypothesis, a cut in the level of a common-stock cash dividend has a negative connotation regarding the corporations' future earnings prospects.2 If preferred stockholders interpret this as a signal that future preferred dividends may be endangered, the price of the preferred stock will tend to fall. However, agency theory suggests that the dividend cut may cause a wealth transfer which will tend to offset this decline. Without contractual arrangements which fully protect senior claimants from expropriation by the common shareholders, corporate actions which increase the firm's leverage may transfer wealth from the senior securityholders to common shareholders.3 On the other hand, dividend cuts which reduce leverage will tend to lower common-stock prices and raise the prices of unsecured senior securities, including preferred stock, via the wealth-transfer effect. In summary, although the information-content and wealth-transfer effects reinforce each other in tending to reduce common stock prices, the net change in the prices of preferred issues will depend upon which effect is more powerful.