Preferred Stock Research Articles

Security Design in Production Economy with Flexible Information Acquisition

This paper looks into security design in a production economy with a new informational friction. It highlights the investor as an expert, who may acquire costly information on the market prospect of the entrepreneur’s project and then screen it through nancing decisions. Thus, real production depends on information production, while these two are separated, which constructs a friction. Debt is optimal when the dependence of real production on information production is weak and thus the friction is not severe, and convertible preferred stock is optimal when the dependence is strong and thus the friction is severe. Such a dichotomy is unied under a new interaction between the payo structures of securities and the exible incentives to screen regarding attention allocation. Both the optimal securities and their correspondences to economic environments t in line with empirical evidence. A new approach, exible information acquisition, characterizes information sensitiveness of securities and attention allocation of investors in a state contingent way, which enables us to work with arbitrary securities on continuous states without distributional assumptions and delivers sharper predictions.

Analysis of Financial Products of Capital Market in Bangladesh: Present Status and Future Development

The performance of existing financial products is an important issue in the capital market to increase the new products for reducing the risk of dependency on common stocks. The research aims are to evaluate the growth and development of existing financial instruments and to recommend for introducing new financial instruments in the capital market of Bangladesh. The data are taken from the Dhaka stock exchange for the year 1977 to 2010 for interpretation of development and the data from 2003 to 2010 are taken for analysis and hypothesis test. There are only five products traded including three types of bonds. The average growth rate of market capitalization of common stocks, treasury bonds, mutual funds, corporate bonds & debentures are 71.02%, 124.74%, 99.85% and 105.41% respectively. The growth of market capitalization of all products is high. There is lot of scope in the market for absorbing the new products. The share of common stocks, treasury bond, corporate bond, debentures, mutual funds to total market capitalizations are 87.73%, 12.25%, 0.24%,0.17% and 0.83% respectively. The market is common stock based. The corporate bond market is very small. So, there should be increased new financial instruments in the capital market to reduce the dependency on share only. The proposed financial instruments are various types of preferred stock, bond, SWAP, option, futures, and forwards as recommendation.

Pitfalls in Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuations1

The “levering” and “unlevering” of estimates of beta and various costs of capital are routine steps in estimating the discount rates used in DCF valuations. But as the authors demonstrate by reviewing the existing research on the subject, the levering and unlevering formulas that are most commonly used in practice are not appropriate for valuing many companies. They also illustrate the shortcomings of—and substantial valuation errors that can result from—the common practices of assuming that the betas of securities like debt and preferred stock are equal to zero and ignoring the effects of equity‐linked securities such as employee stock options, warrants, and convertible debt.The authors offer alternative levering formulas that are more appropriate for valuing most companies than—and as readily implemented as—the formulas commonly used today. They also provide a relatively easy way to estimate betas for debt and preferred stock that can be used in the levering and unlevering formulas. The authors discuss how properly to account for equity‐linked securities such as employee stock options, warrants, and convertible debt while demonstrating the potential importance of ignoring such equity‐linked securities in the levering and unlevering formulas. Finally, the authors show why it is appropriate to standardize the treatment of contractual obligations such as leases across comparable companies in order to get consistent estimates of the unlevered cost of capital.

Investment Risk and Shareholder's Rights in the Italian Public Companies with a Complex Financial Structure

The objective of this research is to examine the status of the principle of correlation between management power and risk in the context of the regulatory framework of Italian public companies, as it emerged after the enactment of corporate law reform in 2003. This research focuses on the instruments through which the articles of association of a company might distort the proportionality between invested resources and voting right, even for the purpose of restricting shareholder opportunism and of ensuring a creditor voice in governance structure. This essay analyzes the special share classes that may be issued by Italian public companies, such as preferred stocks, redeemable shares, tracking stocks, nonvoting stocks, limited-voting stocks, shares with a voting right subordinated to the existence of not solely discretionary conditions. Special attention is paid to those participating financial instruments introduced by the 2003 reform. Lastly, the paper examines the issues of corporate governance that may arise from an excessively complex financial structure in a company, with a particular focus on the conflict of interest among shareholders.

Impact of the TARP financing choice on existing preferred stock

The October 14, 2008 TARP program mandated a forced issuance of TARP preferred stock by the largest U.S. banks. Soon after, many smaller banks were not forced but chose to issue TARP preferred stock after being approved for issuance. We investigate the impact of TARP preferred issuance upon bonds, preferred stock, and common stock. In particular, we focus upon two different types of outstanding preferred stock. These two different types of preferred stock are (1) trust preferred stock, which is senior to TARP preferred stock, and (2) non-trust preferred stock, which has equal claim to TARP preferred stock. We present competing theories for expecting that trust preferred should enjoy greater or lesser returns relative to non-trust. Consistent with the priority rule theory, but inconsistent with the default theory, we find that trust preferred enjoyed greater benefits from TARP issuance than did non-trust preferred for both forced and non-forced banks on the October 14 TARP announcement date. In contrast, there is no clear priority rule effect on the approval dates for non-forced banks.

Convertible Preferred Stock, Antidilution Clause, and Venture Capital Finance

This article uses a contingent-claims method to investigate how the provision of antidilution clause combined with the issuance of convertible preferred stock affect the entrepreneur’s incentive to exert efforts to improve the prospects of the operation of an investment project. For plausible parameter values, we find that the issuance of preferred stock induces the entrepreneur to declare bankruptcy earlier when either the size of uncertainty is larger, or the bankruptcy cost is smaller; which are opposite to the results that found in the straight bond model of Jou and Lee (2004). Furthermore, under the provision of an antidilution clause and assuming that the costs of exerting efforts are negligible, the entrepreneur will be more willingly to exert his efforts to increase the expected growth rate, or reduce the volatility of cash-inflow of the investment project, rather than reducing the upright investment cost upon investment, although all the three strategies can increase the entrepreneur’s expected value.

Valuing TARP Preferred Stock

This is the only paper to provide a valuation framework for untraded Troubled Asset Relief Program (TARP) preferred stock. Up to $8.1 billion of bailout preferred stock, which is currently paying dividends, could be auctioned to investors. The first auction was held in March 2012. This paper provides a framework to estimate future dividend skipping rates and the rating of unrated and untraded preferred stock issues. It provides a valuation model for non-distressed issues. The model in the paper accurately predicted that the auction of MainSource Financial Group (MSFG) would raise about $53 million.

Contingent Payout Functions for Firms with Capped Participating Preferred Stock

Participating preferred stock, currently the most common security choice for venture capital investing, is typically capped to some multiple of its liquidation preference. Capping participation rights complicates payout functions when multiple securities are involved. Presented here is a general solution for payout functions for a firm having multiple classes of capped participating preferred stock. The solution involves the use of firm-recursion to determine the order in which the firm's securities cap and convert, followed by the consequential distribution of incremental proceeds to the various securities.

The choice between publicly issued and privately placed preferred stocks

PurposeThe purpose of this paper is to empirically test information asymmetry and agency conflicts hypotheses, as to firm's choices in selling preferred stock in public and private markets.Design/methodology/approachUsing firm‐level preferred stock issue data, the author uses a multivariate logistic model to see a firm's different preferred stock selling decisions among public market, rule 144A market, and non rule 144A market. The paper examines the impact of the firm's idiosyncratic risk and cash flow volatility.FindingsIt is found that private placement (non rule 144A) firms have higher information asymmetry than public offering firms. In addition, private placement (rule 144A) firms have higher operating risk than public offering firms. The non Rule 144A market and rule 144A market for preferred stocks are significantly different.Research limitations/implicationsThis topic can be further studied with more detailed, preferred stock issue data.Originality/valueThe paper extends our understanding of the preferred stock market selling mechanism.

Invisible Pension Investments

A large share of the more than $5.5 trillion in private pension plan assets is held in certain types of indirect investment vehicles. If those vehicles file their own annual return with the Department of Labor they are called filing entities (or DFEs), and pension plans that invest in them are excused from providing detailed information concerning the assets, liabilities, and investment performance of the DFEs. Consequently, the publicly-available summary financial information reported by pension plans investing through one or more DFEs is seriously incomplete: while a plan must identify the categorical nature of its direct investments (for example, as common or preferred stock, corporate or government debt, real estate, etc.), indirect investments through a DFE are reported only as interests in the DFE, without regard to the underlying nature of the DFE‘s assets and liabilities. Matching the DFE‘s return with the returns filed by plans that invest through the DFE is theoretically possible, but it is technically difficult and has not been comprehensively achieved.This study undertakes the task of linking returns filed by large private pension plans and DFEs in 2008. After explaining the types of DFEs, summary statistics on the extent of pension plan investment through DFEs and the composition of DFE portfolios are reported. The process employed to link the holdings of each DFE to its investor plans is described, followed by description and analysis of the results. Important differences in the asset allocations of pension plans of various types are revealed, and the portfolio compositions of plans that do and do not invest through DFEs are compared. Because 35 percent of plans that invest in a DFE are found to file internally inconsistent returns which preclude successful linking of DFE financial information to the investor plan, the plan characteristics associated with such deficient filings are investigated. Although the composition of DFE portfolios is currently invisible to plan participants and the general public, we find little evidence that DFEs have been systematically exploited to obscure the identity of pension plan investments. Finally, the results of this study are reviewed in light of the purposes of pension plan financial disclosure. Even if routine, accurate, and comprehensive matching of DFE financial information with investor plans were available, ERISA‘s text and policies support the regulatory formulation of a far more detailed digital disclosure regime.

Graeber Companies, Inc.: Examining Impairment of Equity-Owned Investments

ABSTRACT The Graeber Companies, Inc. case illustrates the implications of the Fair Value Measurements Standard (FASB ASC 820 or IFRS 13) and the Fair Value Option for Financial Assets and Financial Liabilities (FASB ASC 825 or IAS 39) on the accounting and auditing issues regarding fair value accounting. Based on an actual company's experience, the case provides an application of the new standards on fair value measurement, which is one major achievement of the FASB/IASB convergence project. Graeber Companies, Inc. is a 100-year-old financial boutique firm that, through its wholly owned and partially owned subsidiaries, is engaged in financial service activities. One of Graeber's proprietary investments is an equity investment in Advisor Group, Inc. (AGI)—an early stage development company. Students evaluate AGI's financial performance and strategic activities, including operating losses, issuance of preferred stock and proposed acquisitions by another investor company relative to its materiality, and potential impairment of Graeber Companies' equity-owned investment. The case study requires a determination of materiality of the equity investment and introduces students to the different valuation techniques such as Discounted Cash Flow Analysis, Public Market Analysis, Precedent Transaction Analysis, and the waterfall schedule method. The usefulness of these methods is then analyzed in determining the fair value of an investment in the situation where there have been no recent market transactions. Through analysis of the financial statements, relevant footnotes, and obtaining/obtained fair market value using different valuation approaches, students make a recommendation on materiality and on the fairness of the Graeber Companies management conclusion that no impairment of its investment in Advisor Group has taken place.

Hester Prynne, Lydia Bennet, and Section 306 Stock: The Concept of Tainting in the American Novel, the British Novel, and the Internal Revenue Code

Did Nathaniel Hawthorne's novel, The Scarlet Letter, inspire 306 of the Internal Revenue Code? This code provision adopts a peculiarly Hawthorne-like solution to a tax avoidance scheme known as the preferred stock bailout. 306 taints the stock used in the scheme as Section 306 Special rules then govern all subsequent dispositions of the tainted stock. With its concept of a taint that can dog a stock from acquisition to disposition, 306 might have been designed by a novelist rather than a tax technician.

Pecking Order Theory and Trade-Off Theory of Capital Structure: Evidence from Indonesian Stock Exchange

Numerous empirical studies in the finance field have tested many theories for firms’ capital structure. The pecking order theory and the trade-off theory of capital structure is among the most influential theories of firms’ capital structure. The trade-off theory predicts optimal capital structure, while the pecking order theory does not predict an optimal capital structure. According to pecking order theory, the order of financial sources used is the source of internal funds from profits, short-term securities, debt, preferred stock and common stock last. The main objective of this study is to econometrically test whether the listed companies in Indonesian Stock Exchange follow the pecking order theory or the trade-off theory. Samples in this study are public companies listed during 2009-2010. The research questions are tested by running regression models. The empirical result of this study shows that the pecking order theory is not supported, while the trade-off theory is supported. This suggests that the capital structure of listed companies in Indonesian Stock Exchange is financed based on optimal capital structure, not by the order financial resources.

An Entrepreneur's Guide to Understanding the Cost of Venture Capital

Entrepreneurs who deal with a venture capital firm (VC) for the first time often find themselves unprepared for the experience. The financing terms (deal structure), which specify the percentage of the firm’s common stock that goes to the VC often require that the entrepreneur forfeit a large proportion of the firm’s equity to the VC. The resulting ownership share is important but it is not the only determinant of the cash distribution rights conferred on the venture capitalist. Specifically, the entrepreneur often grants the VC control rights (the right to fill board seats, voting privileges of a common stockholder even though the VC holds preferred stock or debt, etc.) as well as liquidation rights (the right to be repaid before the common stockholders in the event of the sale or liquidation of the firm) that are not conveyed to the holders of common stock. Consequently, to fully understand the financing terms offered by the VC, the entrepreneur must not only account for cash flow rights, but must also incorporate consideration for control rights and liquidation rights. In this paper we attempt to explain why VCs seek very high rates of return that are so out of line with the returns required of established firms. Our explanation hinges on differences of opinion between an overly optimistic entrepreneur and a less sanguine VC.

Why do public firms issue private and public securities?

The market for public firms issuing private equity, debt, and convertible securities is large. Of the over 13,000 issues we examine, more than half are in the private market. Our results show asymmetric information plays a major role in the choice of security type within public and private markets and in the choice of market in which to issue securities. In the public market, firms’ predicted probability of issuing equity declines and issuing debt increases with measures of asymmetric information. There is a weak reversal of this sensitivity in the private market. We also find a large sensitivity of the choice of public versus private markets to asymmetric information, risk and market timing for debt, convertibles, and in particular, equity issues. In this study we examine why public firms issue different security types within public and private security markets. We study both private and public issues of debt, convertibles, and common equity, a total of six different security-market choices. Our comprehensive database makes it possible to assess the factors that impact both security type and market choice. Private security markets are increasingly important for public firms. Of the over 13,000 issues by public firms we examine, more than half are in the private market, comprising issuances of equity, debt, and convertible bonds and convertible preferred stock (henceforth, convertibles). Among the firms that choose to issue equity or convertibles, 51% of the issues are in the private market, and among small public firms (firms in the lowest size quartile) 73% of their equity and convertible issues are in the private markets. Our study uses a methodology that allows us to determine whether firms use security issuance decisions of multiple types and in different markets as a mechanism to address asymmetric

Summaries of Papers in This Issue

Summaries of Papers in This Issue

Post-Retirement Benefit Plans, Leverage, and Real Investment

This paper shows that off-balance sheet pension and health care benefit plans are important for firm leverage and real investment around the world. Post-retirement assets and liabilities of nonfinancial corporations are economically sizable in many countries (often more than in the U.S.), but are not fully reflected on the balance sheet despite plans generally being underfunded. While consolidating off-balance sheet post-retirement plans typically increases effective leverage by 32%, they do not matter for gearing of firms in about half the sample countries. Moreover, there is significant variation across countries with regards to the extent to which firms with large projected benefit obligations reduce their level of regular debt, ranging from no to perfect substitution. Since postretirement benefit obligations have more flexible terms than regular debt, they can be used as an instrument to investigate the effect of financial flexibility on real investment. The results show that the relation is conditional on the type of investment opportunity (i.e. type of growth option). Postretirement benefit obligations have a positive effect on R&D, which generates growth options, and a negative effect on capital expenditures, which exercises growth options. Compared to an otherwise similar firm without a post-retirement plan, the average plan sponsor has 5.4% less capital expenditures and 13.1% more research and development. The results are robust to other dimensions of financial policy, such as debt maturity, dividends, preferred stock, convertible debt, and leverage that also affect real investment.

Debt overhang and bank bailouts

When a bank is deemed 'too big to fail' by regulators, it may be tempted to buy risky assets. This paper analyses bank bailouts involving the purchases of toxic assets, preferred stock and common stock when the government wants to encourage efficient lending. It finds that preferred stock recapitalisations are the least efficient in correcting debt overhang problems from both an ex post and ex ante perspective. In contrast, efficient lending and voluntary participation can be best achieved without subsidy by purchasing either toxic assets or common stock. Nevertheless, troubled banks must be subsidised if they will voluntarily participate in any recapitalisation.

The Effect of Taxes on Conventional Preferred Stock: Evidence from the 2003 JGTRRA Dividend Tax Reduction

ABSTRACT This study examines the extent to which investor-level taxes affect the pricing and pre-tax returns of securities. Specifically, we investigate whether the pre-tax yield on outstanding conventional preferred stock (CPS) decreased after the 2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) reduced the individual's tax rate on dividends. Our research design for detecting tax effects is strong for two reasons: (1) JGTRRA provides a quasi-experimental setting that permits a pre/post design, and (2) we use trust preferred stock (TPS) issued by the same firm as the tax-disfavored benchmark asset, which permits a matched-pair design that controls for risk. Additional tests including CPS issues without TPS counterparts confirm the effect of JGTRRA on CPS issues. The results indicate that investors reacted to the new tax-favored status of CPS by bidding up its price, which lowered its yield. Data Availability: All data are available from public sources identified in the paper.

Adaptive fuzzy system to forecast financial time series volatility

This paper introduces an adaptive fuzzy rule-based system applied as a financial time series model for volatility forecasting. The model is based on Takagi--Sugeno fuzzy systems and is built in two phases: In the first, the model uses the subtractive clustering algorithm to determine initial group structures in a reduced data set. In the second phase, the system is modified dynamically by adding and pruning operators and applying a recursive learning algorithm based on the expectation maximization optimization technique. The algorithm automatically determines the number of fuzzy rules necessary at each step, and one-step-ahead predictions are estimated and parameters updated. The model is applied to forecast financial time series volatility, considering daily values of the Sao Paulo stock exchange index, the Petrobras preferred stock prices, and the BRL/USD exchange rate. The model suggested is compared against generalized autoregressive conditional heteroskedasticity models. Experimental results show the adequacy of the adaptive fuzzy approach for volatility forecasting purposes.