Professional Documents
Culture Documents
The Effects of Capital Structure Change On Security Prices
The Effects of Capital Structure Change On Security Prices
The Effects of Capital Structure Change On Security Prices
Ronald W. Masulis*
Graduate School of Management
University of California, Los Angeles
Abstract: This study considers the impact of capital structure change announcements on security
prices. Statistically significant price adjustments in firms’ common stock, preferred stock and
debt related to these announcements are documented and alternative causes for these price
changes are examined. The evidence is consistent with both corporate, tax and wealth
redistribution effects. There is also evidence that firms make decisions which do not
maximize stockholder wealth. In addition, a new approach to testing the significance of
public announcements on security returns is presented.
*This is based on my Ph.D. dissertation written at the University of Chicago. I would like to thank my
committee -- Nicholas Gonedes, Albert Madansky, Merton Miller, Harry Roberts, Myron Scholes, and
especially my chairman, Robert Hamada — for their help and encouragement. I have also benefitted
from the suggestions of Walter Blum, Stephen Brown, Paul Cootner, Harry DeAngelo, Lawrence
Fisher, George Foster, Michael Jensen, Roger Ibbotson, John Long, David Mayers, Wayne Mikkelson,
Clifford Smith, Bill Schwert and anonymous referee and participants in finance workshops at Chicago,
Rochester, UCLA and elsewhere. This study was partially supported by the Center for Research in
Security Prices at the University of Chicago. The author takes full responsibility for remaining errors.
Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1542183
http://ssrn.com/abstract=1542183
1. Introduction
Corporate finance theory has not yet determined the consequences of fragmenting
a firm's probability distribution of future market value into classes of securities.
Modigliani-Miller (1958) demonstrate that when production -investment decisions
are held fixed, the value of a firm is invariant to the composition of its capital
structure given a perfect capital market (frictionless and perfectly competitive) and no
taxes. 1 Fama-Miller (1972, pp. 167-170) further demonstrate that under the added
condition of complete protective covenants or 'me -first rules' the values of a firm's
individual securities are invariant to capital structure changes. However, the firm value and
security value invariance propositions can fail under cor porate and personal taxation
(or bankruptcy costs) and under incomplete protective covenants, respectively. In short,
various currently held theories make very different predictions as to the relationships
between capital structure and the valuation of the firm and its individual securities.
Classic microeconomic theory presumes that firms act solely to maximize securityholder
wealth or firm net present value. But Jensen –Meckling's (1976) careful exploration of
the agency relationships of corporate organization suggests that incentive conflicts can
motivate maximization of stockholder wealth or management wealth at the expense of
firm value maximization. In a similar vein, Bulow–Shoven (1978) analyze situations
where management is induced to maximize wealth of debtholders. Thus, the
existence of incentive conflicts provides a variety of motivations for capital structure
changes.
This study tests the predictions of many of the currently held th eories by analyzing
the effects which particular capital structure changes have on the market prices of the
firms' securities. Other studies have not controlled for asset structure changes which
occur at the time of capital structure changes. 2 This study avoids this problem by
1 Modigliani-Miller assumed that a firm's debt was riskless. However, this was later shown to be only a simplifying
assumption; see Fama-Miller (1972) for risky debt with perfect me-first rules and Fama (1978) for risky debt without
perfect me-first rules.
2
For instance, a new issue of debt involves a cash inflow while a repurchase of equity causes a cash outflow.
These simultaneous cash flows result in equal changes in the value of the firm's assets and, in general, change
the distributional properties of the firm's asset structure at the exact moment of the capital structure change.
Consequently most recent studies of capital structure changes are contaminated by simultaneous asset structure
changes. Boness-Chen-Jatusipitak (1974) studied the impact of issuing additional debt by 33 utility companies on
common stock weekly residual rates of return; Kim-McConnell-Greenwood (1977) studied the impact of forming
24 captive financing subsidiaries on the common stock and long term debt monthly residual rates of return; and
Masulis (1980) studied the impact of the announcement of 199 stock tender offers on common stock daily rates of
return. An earlier study by Scholes (1972) analyzed the impact of announcements of 696 rights issues for common
Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1542183
http://ssrn.com/abstract=1542183
analyzing two instances where corporate financial decisions result in close
approximations to pure capital structure changes: intra-firm exchange offers and
recapitalizations. These two events are unique in that they do not entail any firm cash
inflows or outflows (with the exception of expenses), while they cause major changes in
the firm's capital structure. These changes are effected through a private exchange between
the firm and one or more classes of its securityholders.
Section 2 reviews the current theories of optimal capital structure and sets forth the
predicted price adjustments for major security classes according to the type of exchange
offer announced. Section 3 describes the exchange offer process and the related data
sample. Section 4 introduces a new metho dology for testing the significance of exchange
offer announcements on the portfolio rates of return of the firms' common stock,
preferred stock, and debt. Section 5 presents portfolio daily returns surrounding tender offer
announcements for major security classes. The security returns comprising these
portfolios are further segregated by type of exchange offer to isolate their potential
economic causes. Section 6 summarizes the findings and implications of this study.
stock on common stock monthly rates of return. It is significant that in each of these studies the common stock's
announcement return was directly related to the direction of the leverage change.
3
For a description of the assumed relationship between the firm value and the values of risky debt and
equity, see Black-Scholes (1973) and Merton (1974) and for the relationship between firm value and the value of
preferred stock, see Merton (1974).
4
A somewhat different argument is made by Kraus-Litzenberger (1973), Brennan-Schwartz (1978) and Kim
(1977) who link the usefulness of the debt tax shield to t he probability of solvency. Their models also imply
that the present value of the debt tax shield increases at a decreasing rate since the probability of bankruptcy is
rising with the increase in debt.
5
Warner's (1976) estimates of the direct costs of bankruptcy for a limited sample of railroads indicate that their
magnitude is small relative to firm value. Also, there are the previously mentioned leverage related costs, which
Jensen-Meckling define as agency costs.
Unlike the previous two hypotheses, which predict changes of the same sign in both
firm value and security prices, the wealth redistribution hypothesis predicts
offsetting changes in the values of individual classes of securities and no change in firm
value. Protective covenants or me-first rules are defined as incomplete if management can
change the firm's asset or capital structure to redistribute wealth among classes of
securityholders (Fama-Miller). 6 As Jensen-Meckling clearly show, securities with
incomplete protective covenants can exist because the costs of monitoring and enforcing
complete protective covenants exceed the value of the protection obtained from having
them (in terms of higher security prices). 7 In other words, given that securities with
incomplete protective covenants are less costly to supply due to lower monitoring and
enforcement costs, and given that investors assess these securities to be less valuable
due to the probability of future losses, we should observe these securities to have lower
market prices than otherwise equivalent securities. 8 Consequently, while holders of
outstanding securities with incomplete protective covenants (particularly preferred stock
and debt) are subject to potentially adverse redistributions of wealth, they receive
implicit market determined compensation for being subject to these potential losses
through the security's lower purchase price.
Capital structure changes can induce redistributions of wealth when there are explicit
or implicit limitations in securities' protective covenants. Protective covenants are
explicitly incomplete if one or more classes of senior securities fails to strictly preclude
increases in the amount of securities of equal or senior standing. 9 Protective covenants
are implicitly limited if the courts choose not to adhere strictly to the 'absolute
priority rule’ 10 in the adjudication of bankruptcy cases. This rule states that in any
plan of reorganization, 'beginning with the topmost class of claims against the
6
See Fama-Miller and Fama (1978) for further discussion of protective covenants. Smith-Warner (1979)
describe alternative types of protective covenants.
7
See Galai-Masulis (1976), case study 2 in particular and also Litzenberger-Sosin (1977) for examples.
8
Even without the existence of transaction costs of supplying protective covenants, securities with incomplete
protective covenants sell at a lower price due to demand side considerations alone as Black-Cox (1976)
demonstrate for some special cases with incomplete protective covenants.
9 The existence of transaction costs of changing the asset or capital structure offers a certain degree of 'natural
protection' to securityholders with incomplete protective covenants, since in both cases there are transaction costs
borne by the firm in the process of redistributing wealth among classes of securityholders, Technological
limitations on the number of profitable investment projects also offer some measure of natural protection.
10
For a further discussion of this legal definition, see Blum (1958) an d Blum-Kaplan (1974).
Under an exchange of preferred stock for existing common stock, out standing
preferred stockholders experience an adverse redistribution of wealth analogous to
that experienced by outstanding debtholders in the previous case, while the impact on
common stockholders is qualitatively identical to the previous case. Furthermore, there
is no direct impact on the debtholders from explicitly incomplete covenants.13
Under an exchange of debt for existing preferred stock, preferred stockholders who are
able to convert at least a portion of their lower priority preferred s toc k c lai m s for
hi gher pri ori ty deb t c lai ms at thei r pre - announcement prices are made better off at
the expense of the outstanding debtholders. Due to explicit and/or implicit limitations
in protective covenants, the debtholders now bear greater risk of default, but receive
the same interest payments from the firm. Preferred stockholders who do not or cannot
convert their preferred stock to debt are hurt because claims of equal standing are
elevated to senior standing, thereby increasing the preferred stock's risk of loss.14
11
See Collier on Bankruptcy (1972, 6A id. 11.06 pp. 613-617).
12 However the degree of compensation to more senior claimants will generally exceed the degree of
compensation paid to junior claimants for their respective claims on the i nsolvent firms.
13 However, debtholders can experience a small negative effect from implicitly incomplete covenants since the
level of priority of junior claims has increased. Specifically, the issuance of preferred stock for common stock increases
the probability that in a bankruptcy/reorganization the junior securityholders will receive a larger share of the firm's
assets.
14 Under implicit covenant limitations common stockholders can be hurt to a small extent, because in an
involuntary reorganization common stockholders can still receive some payment from the firm but the size of this
payment is diminished as the preferred stock is converted into higher priority debt claims.
Table 1 summarizes the predicted effects of capital structure change given by the three
hypotheses: interest deductibility under corporate taxation, expected costs of
bankruptcy and reorganization and wealth redistributions under incomplete protective
covenants. Observed security price changes can reflect the impacts of all three
hypotheses. There are three categories of capital structure change shown: exchanges
of debt for outstanding common stock, exchanges of preferred stock for outstanding
common stock and exchanges of debt for outstanding preferred stock. The qualitative
predictions of the three hypotheses are given for the change in market values of each major
class of firm securities. It is assumed in each case that the senior security is being
issued to retire the junior security. 15 It is important to note that when firm debt is
increased the predictions of the corporate tax hypothesis are opposite from those of
the expected cost of bankruptcy hypothesis. On the other hand, while these two hypotheses
individually make uniform qualitative predictions for the values of each of the firm's
major classes of securities, this is not the case for the predictions of the re -
distribution of wealth hypothesis. The differential predictions described in Table1 are
important for the interpretation of the empirical results.
15
The debt and preferred stock on table 1 are assumed to be nonconvertible securities. If this were not the case, the
security would experience not only the effects of otherwise similar nonconvertible securities but also the effects
experienced by the common stock into which the security is convertible.
Generally speaking, an exchange offer gives one or more security classes the right to
exchange part or all of their present holdings for a different class of firm securities.
Although generally open for , one month, the offer is often extended for an additional
number of weeks just prior to the initial expiration date. The terms of exchange
offered to the tendering securityholders typically involve a package of new securities of
greater market value (in terms of pre-exchange offer announcement prices) than those
being tendered, with the difference in these securities' values considered an exchange
offer premium. Most exchange offers state a maximum number of securities which can be
exchanged and a maxim um duration for the offer. Indenture restrictions on the
firm generally limit the magnitude of any repurchases of common stock through new
issues of preferred stock or debt. In addition, many offers are contingent upon
acceptance by a minimum number of securityholders. The exchange offer process
generally lasts four to five months during which the firm issues a number of
announcements regarding the proposed exchange. On average, initial announcement
dates precede the beginning of the exchange offer by nine weeks, and the average life of
the offer is about seven weeks.16
In contrast to the voluntary securityholder participation and relatively long time
period an exchange offer is open, recapitalizations generally require the participation of all
16
A few firms announced exchange offers with unusually long intervals between the initiation of the offer and
its termination date. While this implies a longer delay before the capital structure change is to occur, and
hence a possible impact on the size of the security price changes, no further analysis is made due to the small
number of events involved.
10
With respect to personal income taxation, the most important feature of the tax code
is that the corporate income tax deductions derived from interest payments, original
issue discounts, and redemption premiums are personal income tax liabilities of the
debtholders. Thus, any change in the corporation's taxable income has an equal, though
opposite, effect on the taxable income of investors acquiring or tendering this debt. This
does not mean that the taxes paid to the government are invariant under this
voluntary transfer of tax liabilities, because the marginal income tax rates of the
17
'For a more extensive discussion of recapitalizations, see Guthmann-Dougall (1962).
18
Recapitalizations comprise a relatively small portion of our sample (23 events out of a total sample of 163 events).
19
See Bittker-Eustice (1971) for a more thorough discussion of the tax questions covered here.
20
See Section 368(a) (1) of the Internal Revenue Code
11
Stockholders can also incur a capital gains tax liability by tendering their stock for
debt just as if they had sold their stock for cash. 21 Thus, these offers often occur when
the stocks are selling at historically low prices, a point at which most stockholders incur little
or no capital gains liability on the exchange of their stock for debt.
Firms making exchange offers incur significant expenses in this process, including
compensation paid to broker–dealers, accounting and legal fees for registering the
securities under Federal and State security laws, and stock transfer taxes. Estimates of
the cost of direct administrative and legal services, assuming the offer is fully subscribed,
range between 0.1 percent and 10 percent of the market value of the common stock prior to the
initial offer announcement. These cost estimates average about 2 percent of the stock's
value. Consequently, even if the change in capital structure has no tax, bankruptcy
cost, or other effects on firm value, these transaction costs alone would result in a small
negative effect.
21
If, after tendering shares, the investor holds 80 percent or more of the firm's shares and voting control which
he initially held, this repurchase may be treated as a cash dividend under Section 302 of the Internal Revenue Code.
22
This evidence is obtained from exchange offer prospectuses.
12
(1) Only offers with a determinate initial announcement date and by companies
having common stock listed on the NYSE or the ASE at the time of the proposal were
included.
(2) Only offers which alter the level of debt or preferred stock outstanding were
considered (offers must involve more than one major class of firm securities, i.e., common,
preferred, or debt).24
(3) Cash and other asset distributions associated with the exchange offer were limited
to a maximum of 25 % of the value of the affected securities being tendered in the offer.
(4) Firms with announcements of other major asset structure or capital structure
changes which were made wi thin one week prior to or following the initial offer
announcement were excluded.25
Of the 188 offers initially found to meet the first two criteria, 163 remained after the
entire screening process. 26 Even after passing this screening process, the offer must still
23
About 85 percent of these firms responded positively to the questionnaire and, in most cases, provided copies
of relevant press releases and other related material.
24
1f debt, common and preferred stock are all involved in the exchange offer, it is required that the
change in debt and preferred stock out standing be in the same direction while the change in common
stock outstanding be in the opposite direction. Exchanges whose sole effects are to increase debt coupon
rates and weaken indenture covenants, increase debt maturity, or increase debt coupon rates while
decreasing debt face value, are among those events excluded from this analysis.
25
Thus, announcements of new issues, redemptions or repurchases of securities, mergers, acquisitions,
spinoffs, major new investments, large new contracts and large cha nges in net income which exceed 25
percent of the value of the securities tendered in the offer, as well as announcements of changes in
dividend policy, late payment of debt interest, impending bankruptcy, major discoveries, and new
patents which were made within one week of the initial offer announcement disqualified those events from the
sample.
26
There are 19 and 6 events eliminated by criteria (3) and (4), respectively. Of the 19 events eliminated
13
Daily rates of return for preferred stock are calculated for the ten trading days before
and after the initial exchange offer announcement data using the closing prices listed in
Standard and Poor's NY SE Daily Stock Record and ASE Daily Stock Record. Bid-ask averages
are used when traded prices are unavailable, and cash dividends are added to the rates of
return on their ex-dividend dates.
Bond rates of return arc also calculated for ten trading days around the initial
by criterion (4), almost all were the result of other an nouncements made on the date of the initial exchange
offer announcement. In addition, one should note that of the 163 events in our sample, 29 indefinitely postponed
or cancelled their offers.
27
Exchanges having a cash or asset component in the offer less than 25 percent of the newly issued
securities' value represented 23 events in the final sample.
28
Criterion (4) could in principle induce some selection bias in the results, in that exchange offers may be
associated with the signalling of insider information concerning firm value and risk would be partially filtered
out by our sample criteria.
14
4. Methodology
For this analysis, portfolios are formed in event time; so that each p o r t f o l i o
d a i l y r a t e o f r e t u r n r e p r e s e n t s a n a v e r a g e o f s e c u r i t y returns for a common
event date. The event date is defined as the number of trading days before or after the
announcement date under scrutiny, where day 0 is the date of the actual announcement.29
Security returns are not calculated for days when security prices are unavailable,
and as a result these securities are not included in the portfolio returns for these days. If a
trading halt in the security occurs on the day after the announcement date, then the next
trading day’s price is substituted for the day 1 closing price, so that the announcement
effect will not be obscured.
29
Earlier studies using this approach include Fama-Fisher-Jensen-Roll (1969), Jaffe (1974), Ibbotson (1975) and
Ellert (1976).
15
while it = 1 means that a specific capital structure change is announced by firm i at
As shown in Table1, the sign of E(͂it it = 1) is a function of the security class and the
type of capital structure change announced. Consequently, if such an announcement is
known to have occurred in a given period, the security's conditional expected return
30
For a further discussion of this point, see Ross (1976).
16
In order to assess the impact of new information on security prices, it is nec es s ary
to s eparate it from the an nounc em ent peri od returns by subtracting out an
estimate of µit. The conventional approach to estimating µit is to first estimate a
variant of the market model which specifies a statistical relationship between
contemporaneous security and market returns (the most widely used formulation being
r͂it = αi + βi r͂mt + ͂it* . The market's announcement period return is then substituted
into the estimated relationship to yield µ̂it = α̂i + β^i rmt.31
An alternative approach for estimating µit termed the Comparison Period Returns
approach, is utilized in this study. In this alternative approach, a security's mean return
µit is estimated from a time series of the security's returns over a representative
period (not including the announcement period) which is defined as the comparison
period. This yields an unbiased estimate of µit, given that the security's return process is
stationary over the period of observation. Once µ̂it is determined, the announcement
period disturbance term it can, in turn, be estimated. Since µit is not known for certain in
either approach, estimation error will exist in ̂it and furthermore, the disturbance term can
be affected by other factors in addition to the announcement under study (such as
deviations from the mean return on the market). However, since the first of these two
influences on ̂it is independent across securities, its impact can be minimized by forming a
'portfolio' in event time of these individual securities experiencing a common
announcement effect. Furthermore, when the sample of announcement dates is
strictly non-contemporaneous in calendar time, the latter influence on ̂it will be
independent across securities in event tim e, regardless of whether the impact of the
market return has been subtracted out or not.
Under the Comparison Period Returns approach, it is useful to view the portfolio's
announcement period expected return as equal to the average of the individual
31
This approach assumes that the correct specification of the market model is being estimated and that this
relationship is stationary over the observation period. Note that µit includes the stochastic market-related disturbance
term, so that ͂it * is a security-specific disturbance term; while in the Comparison Period Approach ͂it includes a market-
related disturbance term.
17
it = 1) plus the portfolio's comparison period expected return. Consequently, a test of
whether or not the announcement period disturbance term is zero can be formulated by
simply testing whether the announcement period mean return is significantly different
from the comparison period mean return. In the alternative market model approach,
one tests whether or not the announcement period return minus µ̂it, is significantly
different from zero.
Assuming that portfolio daily returns and percent of security returns positive are
normally distributed and stationary, significance tests of leverage change announcement
effects on security prices can be constructed. Under these assumptions, a conventional t test
for the equality of announcement period and comparison period means is used to test the null
hypothesis of no leverage effect against the alternative hypothesis of a positive or
negative leverage effect depending on the particular hypothesis under consideration. 33 In
32
Further, there is a condition on the smallness of the absolute third moment which must also hold; see Dhrymes
(1970, pp. 104-105). One could alternatively standardize the individual security returns by their respective
standard deviations estimated over the time period prior to the comparison period to increase the rate of
convergence of the distribution to a normal distribution.
33
See Mood-Graybill-Boes (1974, p. 435). This is a standard difference of means test statistic which is t
distributed with parameter T1 + T2 - 2,
t = (r͂1 – r͂i0)/
{ (T 1 - 1)s 1 2 + (T 2 – 1 )s 2 2 } / (T 1 + T 2 - 2 ) { 1/T 1 +1 /T 2 }
where T 1 = number of portfolio daily returns in the comparison period, T 2 = number of portfolio daily
returns in the announcement period, r͂ 1 =portfolio's comparison period mean daily return, s 1 = standard
deviation of the comparison period mean return, r͂ i 0 = portfolio's announcement period mean daily
18
Applying the Comparison Period Returns approach in this study, it is assumed that
the appropriate length of the comparison period is 60 trading days before and after the
initial announcement date for common stock and 10 trading days before and after the
initial announcement date for preferred stock and debt. To evaluate the reasonableness
of this procedure, Masulis (1978) compared the pre- and post-announcement subperiods
of the overall comparison period. On the whole, the data indicates that the two subperiods
exhibit very similar mean returns, and that aggregating these subperiods has little effect
on the comparison period returns' mean and standard deviation, relative to the
magnitude of the announcement effect. 34
return, and s 2 = standard deviation of the announcement period mean daily return.
The test procedure used here is similar in spirit to tests using a matched pair comparison, though the
pairs are of unequal size. Note that this t test assumes that the true standard deviations for the two
periods are equal.
34 A t test for the difference between the two means could not reject the null hypothesis of equal means
at a 5 percent significance level. Implicit in the use of pre - and post-announcement returns is the
presumption that the security's unconditional expected return ki t , is unaffected by the announcement being
studied, and therefore that the security's post -announcement comparison subperiod mean return is
likewise unaffected. In the case of exchange offers, it is presumed that any leverage induced changes in
security risk and expected return occur beyond the end of the comparison period. Specifically a change in
leverage will cause a like change in the risk and expected return of the firm's common stock at the time of
the capital structure change under Proposition II of Modigliani-Miller (1958). Note that an announced
future change in leverage has no impact on the stockholder's risk bearing in the interim period prior to
the actual period of the leverage change. Consequently there should be no change in the stock's expec ted
return in the interim period. For the exchange offer sample being studied, the initial offer announcement,
on average, precedes the actual capital structure change by four months, which is considerably beyond the
end of the chosen comparison period. If this were not the case, the comparison period should be restricted to
the period preceding the initial announcement date. One exception to this argument is the secondary
leverage change caused by a change in firm market value, which is assumed to be empirically insignificant.
35
However, the announcement effects were tested for significance using various standard market model
approaches where similar findings were obtained, as described in Masulis (1978).
36
See the discussion by Roll (1977), Gonedes (1973) and others.
19
5. Empirical results
In the results to follow initial announcement effects for increases and decreases in
leverage on common stock returns are presented. The sample of common stocks is
segmented by type of exchange offer into returns predicted to exhibit tax and offsetting
bankruptcy effects, only redistribution effects and all three effects. The sample of preferred
stocks is likewise segmented by type of exchange offer into returns predicted to
exhibit tax and offsetting bankruptcy and redistribution effects, only redistribu tion
effects, and tax, redistribution and offsetting bankruptcy effects. In analyzing debt,
convertible issues are separated from non-convertible issues, and their respective returns
segmented into exchange offers predicted to cause tax and offsetting bank ruptcy and
redistribution effects or no effect on debt prices. Lastly, debt returns of issues having
obviously incomplete protective covenants, which are predicted to exhibit larger
redistribution effects, are separated from the returns of other debt issues.
A basic question this study seeks to answer is whether or not an alteration in a firm's
capital structure has any measurable impact on its securities' prices. A partial answer to
37
This conclusion should he even stronger in the case of daily returns as used in this study since the significance of
the market model as indicated by its R2 is much lower for daily data than for monthly data.
20
38
It is virtually impossible to determine whether an announcement is made before or after the close of the stock
market; if the latter is the case, the effect should not be seen in the rate of returns until day 1. Furthermore, if
the news media is the source of the initial public announcement, it is presumed that the announcement actually
occurred on the previous trading day. This means that weekend announcements appearing in print on Monday will be
incorrectly attributed to the previous Friday.
39
This is compared to a mean of 42 percent of these stocks having a two-day positive return for the twenty-day
comparison period surrounding the announcement period. The low percent of stocks having a strictly positive
two-day return reflects the significant probability that a realized return can equal zero due to either non-trading of
the security, or a price change that is less than $1/8.
21
22
40 Note that the positive tax effect experienced by the portfolio of common stocks does not necessarily imply a
linear relationship between a change in debt outstanding and the change in common stock value as in the prediction of
the Modigliani-Miller (1963) tax model. This result is also consistent with a concave relationship such as that
predicted by the Brennan-Schwartz (1978) model.
23
41
A number of additional exchange offer related announcements are studied in Masulis (1978), however, these
announcement effects were small in magnitude and generally not statistically significant with the exception of the
announcement of the offer terms or alteration of terms.
42
Since the data on the cancellation announcements was less accurate, trading day -1 was also included in the
announcement period.
24
25
The 23 preferred stock issues associated with the 18 debt -for-preferred exchange
offers are predicted to experience both positive redistribution and corporate tax effects
and a negative bankruptcy cost effect. 44 The lower half of Figure 2 shows -a large positive
portfolio return of 3.4 % for the two-day announcement period with an associated t statistic of 6.2,
indicating that the announcement period mean daily return is significantly different from
the comparison period mean daily return. This result, representative of both
convertible and non-convertible preferred stock issues, is consistent with the predictions of
both corporate tax and redistribution effects.
43
Convertible and non-convertible preferred stock issues are separately analyzed by type of exchange offer.
However, for brevity, these results are only summarized.
44
In cases where preferred stock is being retired, only issues of preferred stock involved in the offer are included in
the portfolios; as is assumed in table 1.
26
45
Given that no effect is predicted for preferred-for-common exchange offers, the debt issues associated with these
offers are excluded. Separate tests of this prediction were not made due to the very small sample size involved.
46
For a more in-depth discussion and survey of standard anti-dilution clauses, see Kaplan (1965). It is also
possible that the positive tax effect exceeds the negative bankruptcy cost and redistribution effects for this subsample.
27
47
This may not be strictly true since we are not controlling for the magnitudes of the leverage changes in the
different samples.
28
Some important implications for merger studies can be derived from our results. First
of all, it does not necessarily follow that a change in common stock value which occurs on
the announcement of a merger is a reflection of a similar change in firm value. Changes in
the values of the firm's debt and preferred stock (which can potentially be offsetting) must
be analyzed before this inference can be made.
29
6. Conclusions
(1) Capital structure changes predicted to cause either a corporate debt tax shield effect or
a wealth redistribution effect are associated with security price changes consistent with
these predictions.
(2) Security price changes are relatively larger in cases where the corporate tax and
redistribution effects are predicted to reinforce each other, and smaller in cases
where the corporate tax and redistribution effects are predicted to run counter to each
other.
(3) Offsetting price changes in individual firms' major security classes are observed, as
48
Refer to Galai-Masulis for a further analysis of these combined effects.
49
One notable exception is the recent study by Kim-McConnell (1977).
50
For example, see the studies done by Ellert (1976), Mandelker (1974), Hogarty (1970) and Reid (1968).
30
(6) No evidence of a bankruptcy cost effect is found for the firms decreasing leverage in
ease where wealth redistribution effects are not present. This surprising result appears
to be inconsistent with the predictions of the corporate tax–bankruptcy cost models of
optimal leverage.
In summary, the qualitative predictions of the corporate tax and wealth redistribution
effects resulting from a capital structure change are observed, as detailed in Table1, for all
three major classes of firm securities. No evidence of an expected cost of bankruptcy effect
is observed. Nevertheless, it is always possible that a portion of the observed price
adjustment is due to other effects not considered here such as the signalling hypothesis.
This is a question left for future research.
31
32
33
34
Change in
market value Debt for common Preferred for common Debt for preferred
of existing
security Corporate Bankruptcy Redistri- Corporate Bankruptcy Redistri- Corporate Bankruptcy Redistri-
classes tax cost bution tax cost bution tax cost bution
Common Positive Negative Positive None None Positive Positive Negative None or
stock negative
Preferred Positive Negative Negative None None Negative Positive Negative Positive
stock
Risky Positive Negative Negative None None None or Positive Negative Negative
debt negative
*If the direction of the exchange is reversed, security valuation effects presented in the body of the table will be reversed. Note
that the predicted change in a security's value is the sum of these three individual effects.
**This holds only for preferred stock issues involved in the offer.
35
36
37
Event Portfolio daily % of stock Event Portfolio daily % of stock Event Portfolio daily % of stock
day returns (%) returns > 0 day returns (%) returns > 0 day returns (%) returns > 0
-10 -0.22 39.0 -10 0.19 47.0 -10 0.22 53.0
-9 -0.74 27.0 -9 -0.72 28.0 -9 0.14 35.0
-8 0.14 41.0 -8 -0.75 37.0 -8 0.01 42.0
-7 0.49 39.0 -7 0.60 44.0 -7 0.41 35.0
-6 0.19 42.0 -6 0.02 44.0 -6 -1.02 35.0
-5 0.45 38.0 -5 0.52 47.0 -5 -0.23 44.0
-4 -0.04 25.0 -4 0.50 47.0 -4 0.26 35.0
-3 0.23 32.0 -3 -0.90 28.0 -3 1.00 47.0
-2 -0.57 37.0 -2 -0.04 37.0 -2 -0.32 38.0
-1 0.85 43.0 -1 -0.66 35.0 -1 -0.50 24.0
0 6.01 73.0 0 2.13 67.0 0 1.96 69.0
1 3.78 61.0 1 1.21 51.0 1 2.67 56.0
2 -0.06 34.0 2 0.57 51.0 2 -0.65 37.0
3 -0.32 27.0 3 -0.59 35.0 3 0.20 37.0
4 -0.47 25.0 4 0.63 44.0 4 0.26 49.0
5 0.18 39.0 5 -0.94 26.0 5 -0.18 40.0
6 -1.02 24.0 6 -0.22 33.0 6 0.46 42.0
7 -0.20 33.0 7 -0.06 37.0 7 0.25 35.0
8 -0.45 25.0 8 -0.22 33.0 8 -0.43 26.0
9 0.22 36.0 9 -0.58 40.0 9 0.22 40.0
10 0.29 32.0 10 0.09 51.0 10 0.42 38.0
Comparison period Comparison period Comparison period
Portfolio mean daily return = -0.04 Portfolio mean daily return = 0.02 Portfolio mean daily return = 0.06
S t a nd ar d de v iat io n = 0. 54 Standard deviation = 0.51 S t andar d devi at i o n = 0 . 5 5
Mean percent of stock Mean percent of stock Mean percent of stock
daily returns > 0 = 33.0 daily returns > 0 = 40.0 daily returns > 0 = 37.0
Standard deviation = 6.79 Standard deviation = 7.14 Standard deviation = 7.09
38
* To highlight the announcement effect +10 trading days of the sample of +60 days are presented. The data eliminated showed n o large
positive or negative values nor any unusual patterns. The entire table is presented in Masulis (1978).
39