Master Thesis

The economic substance of Mandatorily redeemable

preferred stock

Author:

Gert-Jan van der Maas (333204)

Date:

20 June 2011

Executive summary: Since the introduction of SFAS No. 150 the market perception of stockholders

might change. Due to SFAS No. 150 MRPS is reclassified to the liability section of the balance.

MRPS is an example of a hybrid instrument with characteristics of liability and equity. This study

investigates the market perception of stockholders on MRPS with the help of an event study. This

study investigates 57 sampled firms with outstanding MRPS and listed on the S&P 500. The

study could not find evidence that stock prices decreased significant compared to the market

performance during the four announcements about the reclassification of MRPS. However, the number

of firms with outstanding MRPS decreased during the process of the introduction of SFAS No. 150.

Furthermore, the reaction of stock prices to the third event shows in relation to the other three events a

significant outcome. It seems that stockholders assess the MRPS as a hybrid instrument and therefore

MRPS cannot be classified into only liability or equity.

Keywords: MRPS, SFAS No. 150, hybrid instrument, event study

Master: Accountancy, Auditing and Control

Erasmus School of Economics, Erasmus University Rotterdam

Supervisor: C. van der Spek RA

Preface

This thesis has been written as a part of the master Accounting, Auditing & Control at

the Erasmus University in Rotterdam. My master’s program is part of the study Economics

and Business at the Erasmus School of Economics of the Erasmus University Rotterdam. In

the past academically years I have learned to think and to write as a scientist. The lectures in

de master’s program I followed have given me a theoretical knowledge that I can use in my

career.

I am deeply grateful to my supervisor Van der Spek, family and friends who have

supported me throughout my academic development, especially during the course of this

challenging process of writing my thesis.

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Table of content

1. Topic introduction...............................................................................................................51.1 Relevance.....................................................................................................................51.2 Structure.......................................................................................................................6

2. Research object...................................................................................................................72.1 Statements of Financial Accounting Standards No. 150..................................................72.2 Consequences of SFAS No. 150.......................................................................................82.3 Contribution of this thesis.................................................................................................92.4 The research question.....................................................................................................102.5 Method of research.........................................................................................................11

3. Background information...................................................................................................123.1 Economic consequences.............................................................................................123.2 Equity theories............................................................................................................14

3.2.1 Entity Theory...........................................................................................................143.2.2 Proprietary Theory...................................................................................................143.2.3 Residual Equity Theory...........................................................................................153.2.4 Relation equity theories with this research..............................................................16

3.3 Conclusion.....................................................................................................................164. Literature study.................................................................................................................18

4.1 Literature study..........................................................................................................184.1.1 SFAS No. 150..........................................................................................................184.1.2 Changes in the debt to equity ratios.........................................................................214.1.3 The impact of SFAS No. 150 focuses on financing matters....................................234.1.4 Market perception of the economic substance of MRPS.........................................234.1.5 The relation between leverage and the required rate of return on common stock...284.1.6 Relation between stock prices and required return of common stock.....................32

4.3 Conclusion..................................................................................................................325. Research design................................................................................................................34

5.1 Hypotheses development...........................................................................................345.2 Research method.......................................................................................................35

5.2.1 Assumptions of an event study................................................................................365.2.2 Method of research..................................................................................................37

5.3 Event dates.................................................................................................................395.3.1 research period.........................................................................................................395.3.2 Sample......................................................................................................................40

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6. Results and analysis..........................................................................................................416.1 Descriptive statistics of the sample............................................................................416.2 Results and analysis of the outcomes.........................................................................41

6.2.1 the performed Z-test.................................................................................................426.2.2 Interpretation of the results......................................................................................446.2.3. Results and hypotheses...........................................................................................45

6.4 Conclusion..................................................................................................................467 Conclusion........................................................................................................................47

7.1 Research conclusion...................................................................................................477.2 Limitations.................................................................................................................497.3 Recommendations for future research........................................................................49

Appendix I................................................................................................................................50Appendix II...............................................................................................................................54

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1. Topic introduction

The balance sheet of a firm contains two sides. The left hand side of firms’ balance

sheet details a list of firms’ assets. The right –hand side of firms’ balance sheet shows details

with what kind of sources of capital the assets have been financed. The right hand side of the

balance can be categorized in equity and liability. However, some sources of capital have

characteristics of both liability and equity. This study investigates financial instruments with

characteristics of both liability and equity. More precisely, this thesis reports about the effect

of announcements (events) of the Statements of Financial Accounting Standards No. 150

(SFAS No. 150 hereafter) on stock prices. SFAS No. 150 contains guidelines of accounting

for certain financial instruments with characteristics of both liability and equity. In the United

States of America the FASB is the organization that establishes standards for financial

accounting (FASB.org).

Financial instruments with characteristics of both liability and equity are defined in

the literature as hybrid instruments. A financial instrument can be defined as: ‘Cash, evidence

of an ownership interest in an entity, or a contract that both: a. Imposes on one entity a

contractual obligation (1) to deliver cash or another financial instrument to a second entity or

(2) to exchange other financial instruments on potentially unfavorable terms with the second

entity. b. Conveys to that second entity a contractual right (1) to receive cash or another

financial instrument from the first entity or (2) to exchange other financial instruments on

potentially favorable terms with the first entity.’ (FASB, Statement 133)

1.1 Relevance Alver (2007) notes about financial instruments: ‘Accounting for financial instruments

has been the most controversial area in the development of the IASB’s standards.’ The

Financial Accounting Standards Board (FASB hereafter) and the International Accounting

Standards Board (IASB hereafter) are working together towards a comprehensive standard of

accounting for financial instruments with characteristics of equity, liability, or both (hybrid

instrument). The main problem is how to distinguish liabilities from equity. Therefore, writing

a thesis about hybrid instruments is a relevant topic, because there is an on -going debate

about how to distinguish a liability or an equity instrument between standard setters,

governments and users of financial statements.

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The FASB and IASB are working together to improve and simplify the financial

reporting requirements for financial instruments with characteristics of equity and liabilities.

A project team of members of FASB and IASB will be installed after June, 2011. (Alver,

2006, AAA Reporting Policy Committee, 2009, Gunderson & Swanson, 2010 and FASB,

2010). The results of this empirical thesis can be used to converge the differences between

FASB and IASB standards. The relevance of the topic is described in chapter two in more

detail.

1.2 Structure The structure of this thesis is as follows: chapter two discusses the content of the thesis

including the research question and sub questions. In chapter three a description is given of

several (potential) economic consequences as a result of an issued or changed accounting

standard. Furthermore, the theories about the characteristics of equity and liabilities are

discussed in this chapter. Chapter four discusses several connected articles which are relevant

to the research question. Chapter five describes the research design that is used to answer the

research question and the hypotheses which are based on the literature review. In chapter six

the results of the empirical research are given. Finally, in chapter seven the conclusion is

written.

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2. Research object

2.1 Statements of Financial Accounting Standards No. 150 SFAS No. 150 prescribes for financial instruments representing an obligation that

these instruments should be classified as a liability. An accounting standard like SFAS

No.150 is a reference on how to determine financial information in a financial statement. The

SFAS No. 150 accounting standard requires a reclassification in the financial statement of

several financial instruments. SFAS No. 150 had been effective on May 31, 2003, or since the

beginning of the first interim period June 15, 2003. However, for a non-public entity this

statement had been effective since December 15, 2003.

Reasons for issuing SFAS No. 150

The FASB has issued SFAS No. 150 to improve the ‘decision usefulness’. SFAS No.

150 ‘will result in a more complete depiction of an entity’s liabilities and equity and will,

thereby, assist investors and creditors in assessing the amount, timing, and likelihood of

potential future cash outflows and equity share issuances’ (FASB, 2003). The ‘decision

usefulness’ is an objective of financial reporting noted in the Concepts Statement No. 1

(Objectives of Financial Reporting by Business Enterprises) published by the FASB. Another

aim of the introduction of SFAS No. 150 is to improve the relevance and reliability by

providing users more information about a firm’s obligations. How the changes in SFAS No.

150 improve financial reporting will be further explained in chapter four.

On the other hand the introduction of SFAS No. 150 might have caused economic

consequences for firms and stockholders. Zeff (1978) defines economic consequences as: “the

impact of accounting choices on the decision making behaviour of business, government,

unions, investors and creditors”. Therefore, a change in an accounting standard is not only

focussed on just one single group of a society. For that reason accounting setters like the

FASB need to be aware of the economic consequences of introducing new financial

accounting standards. In chapter three the economic consequences are further described.

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Thesis

This study focuses on the economic consequences of mandatorily redeemable

preferred stock (MRPS hereafter) to stockholders in the United States of America. There is

insufficient data available to perform an empirical research to European firms with MRPS

listed in their balance sheet. MRPS are defined as (FASB, 2003) “any of various instruments

issued in the form of shares that embody an unconditional obligation requiring the issuer to

redeem the instrument by transferring its assets at a specified or determinable date (or dates)

or upon an event that is certain to occur”. The firms with outstanding MRPS possess an

obligation to deliver assets or equity (stock) to the owner. On the other hand they retain basic

characteristics of equity, because holders of MRPS cannot force a firm into bankruptcy for

delinquency of dividend or redemption payments. In conclusion, the MRPS is a hybrid

instrument attributable to SFAS No. 150.

Before the introduction of SFAS No. 150 the MRPS were listed in the mezzanine

section of the balance or classified in the equity section of the balance. Most firms classified

their MRPS in the mezzanine section of the balance before the issuing date of SFAS No. 150

(Nair, et al. 1990). After the introduction of SFAS No. 150 firms have to list MRPS as a

liability.

2.2 Consequences of SFAS No. 150 This paragraph focuses on consequences of SFAS No. 150 discussed in published

scientific articles. These articles will be discussed in chapter four, but this paragraph gives a

short description of consequences on the basis of these articles. Firstly, as a result of the

introduction of SFAS No. 150 the debt to equity ratio of several firms has changed (Schauer,

et al., 2006; Maloney & Mulford, 2003). Schauer, et al. (2006) concluded that US public firms

with preferred stock outstanding have seen their debt to equity ratio increasing by 43 per cent

as a result of the introduction of SFAS No. 150.

Furthermore, a change in the debt to equity ratio might have had an effect on the

required rate of return of a firm - ceteris paribus- . This relation is confirmed by earlier

research of Hamada (1972) and Hill & Stone (1980). In addition, the required rate of return

might affected the stock price of these firms with MRPS. This relation is proved by earlier

studies of Cornell (1999); Dechow, Sloan & Soliman (2004); Lettau & Wachter (2007).

Other research of Gunderson & Swanson (2010) and Hopkins (1996) provide

empirical evidence that users depend on balance sheet categories (equity, liability and

mezzanine), and that diverseness in the liability section may lead to confusion and miss-

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interpretation. Moreover, MRPS is listed as a liability; therefore a firm must pay the holders

of MRPS interest costs instead of dividend. The consequence is a diluting of earning per share

- ceteris paribus -(SFAS No. 150).

Finally, previous research of Levi & Segal (2006) has shown that the proportion of

MRPS in firms’ financing structure declined after the enactment of SFAS No. 150. All the

articles will be discussed in the literature review in more detail. Other consequences of the

introduction of SFAS No. 150 will be discussed in more detail in chapter four.

2.3 Contribution of this thesisPrevious research investigated the impact of the debt to equity ratio to the required rate

of return, the effect of the required rate of return on stock prices and a declined proportion of

MRPS in firms financing structure. These articles have been mentioned in paragraph 2.2. In

this study the focus is on whether the stock prices of firms with MRPS have changed as a

result of the introduction of SFAS No. 150. More precisely, which of the announcements

(events) about SFAS No. 150 had an impact on stock prices of firms with outstanding MRPS?

Therefore, this study will investigate whether stockholders reacted (trade behaviour) on

announcements about the reclassification of MRPS as a liability. As far as I know this

investigation is not been carried out by other students or empirical researchers.

Secondly, there is still an on -going discussion about the classification of hybrid

instruments (instruments with both equity and liability characteristics like MRPS). This shows

the ambiguity in the treatment of preferred stock (Alver, 2006, AAA Reporting Policy

Committee, 2009 and Gunderson & Swanson, 2010 and FASB, 2010). For instance, the

reprehensive of the Associated General Contractors of America, Tax and Fiscal Affairs

Committee claimed: ‘that the reclassification of financial instruments from the equity to the

liabilities section as a result of SFAS 150 would wipe the net worth of small companies in his

industry, and harm their ability to attain public projects.’(Levi and Segal, 2006). To bid on

public work projects some American states require the contractors to show net worth.

Therefore, this empirical study can add value to the evaluation process of standard setters’

organizations like the FASB and the IASB. The IASB (International Accounting Standards

Board) can use the results of this research as well, because the IASB introduced a similar

standard as SFAS No.150.

Thirdly, a change in the debt to equity ratio might have an impact on the required rate

of return. The consequence is that stock prices react on a modified required rate of return.

These two relations have been proven by earlier researchers and have been mentioned before

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(paragraph 2.2). Therefore, managers might be interested in this study when the results of this

study show that stockholders have reacted on announcements of the FASB about SFAS No.

150. If stockholders require a higher rate of return managers might change their capital

structure in reaction to reduce their cost of capital.

2.4 The research question This study focuses on whether stockholders MRPS regarded as a liability or as equity.

The market perception of stockholders about the economic substance of MRPS is

investigated. The FASB decided to classify MRPS as liabilities; the market perception of

stockholders about MRPS could be different. The market perception of stockholders is

measured throughout stock prices.

The introduction of SFAS No. 150 proceeded in several announcements. The question

hereby is which announcement(s) has/have led to a significant reaction of stock prices of

firms with MRPS? If stock prices do not react significant on announcements about

reclassification of MRPS, stockholders regarded MRPS as equity or as a hybrid product

belongs to the mezzanine section of the balance. If a significant change in stock prices can be

measured, stockholders regarded MRPS as liabilities. The effects of the reclassification of

MRPS to the liability section of the balance are mentioned in previous paragraphs.

The research question is formulated as follows:

How did the American Stock prices of firms with mandatorily redeemable

preferred stock react to the announcements (events) of SFAS 150?

This research question will be answered due to the following sub-questions:

1. What are the economic consequences of the reclassification of redeemable

preferred shares, issued in SFAS No. 150?

2. Which events are likely to have a positive or negative effect on the announcements

of the issuance of SFAS No. 150?

3. How can the American stock price reaction of firms with redeemable preferred

stock be measured during the events?

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2.5 Method of research To answer the sub-questions a literature research is performed. In this literature research,

relevant theories and empirical results related to SFAS No. 150, MRPS and the risks of an

increasing debt to equity ratio is presented.

The empirical research is performed in order to answer the research question. To

investigate economic consequences two approaches can be used. These approaches can be

distinguished in the capital market aspect and the behavioural aspect. Both approaches can

determine economic consequences. The capital market approach determines whether releasing

information has an effect on stock prices. In short, the capital market approach focuses on the

aggregated reaction of participants on the capital market. On the other hand the behavioural

approach focuses on decisions of individuals. In this study the capital market approach is

used. Capital market research is based on the assumptions that equity markets are semi-strong

form belonging to the Efficient Market Hypothesis (Deegan and Unerman, 2005, p. 378). This

means that all publicly available information is rapidly reflected into stock prices in an

unbiased manner. The research question can be answered using stock prices; therefore the

aggregated reaction of stockholder is determined.

To give an answer to this research question an event study is performed. The Market

model of Fama et al. (1969) is used. More precisely the model of McWilliams and Siegel

(1997) which is based on the model of Fama et al. (1969) will be guiding for this study. The

details of this model will be further explained in chapter five.

Before the introduction of SFAS No. 150 several announcements have occurred,

which provides information about the reclassification of MRPS to the liability section of the

balance sheet. Examples of announcements are discussion dates, the draft of SFAS No. 150,

the publishing date of SFAS No.150 and, the issuing date of SFAS No. 150.

The introduction of SFAS No. 150 effects firms with outstanding MRPS in the United

States of America. Therefore, only firms that had outstanding MRPS during these

announcements are selected. The data can be collected using Compustat and Datastream. In

chapter five more information is given about the chosen sample and the research method.

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3. Background information

Introduction

In this chapter the term economic consequences is explained with the use of existing

literature. The second part of this chapter describes the various theories on how to distinguish

equity and liabilities.

3.1 Economic consequences Holthausen and Letfwich (1983) stated “economic consequences arise when changes

in the information set reported affects a company’s cash flows or its distribution”. This might

be possible in two different ways. At first, the behaviour of users or the behaviour of

organizations (i.e. managers) might change. Secondly, a firm’s contract (formal or informal)

may be affected.

Zeff (1978) writes in his article about the rise of economic consequences since the

1960s. He notes that there was an increasing consciousness by the accounting profession of

the growing influence of third parties in the process of standard setting and the enforcing of

them. Zeff (1978) describes two developments that characterize the growing influence of third

parties in the standard setting process. “First, the groups that are rarely interested in the setting

of accounting standards began to intervene actively and powerfully in the process. Second,

these parties began to invoke arguments (other than those which have traditionally been

employed in accounting discussions.” These arguments are described as ‘economic

consequences’.

Economic consequences are formulated by Zeff (1978) as follows: “…the impact of

accounting reports on the decision making behaviour of business, government, unions,

investors and creditors.”

Scott (2003) describes economic consequences and notes that “economic

consequences is a concept that asserts that, despite the implications of efficient securities

market theory, accounting policy choice can affect firm value”.

These definitions of Scott, Zeff and Holthausen & Letfwich about economic

consequences can be connected to SFAS No. 150. The influence of SFAS No. 150 has an

impact on the debt to equity ratio of a firm and the earnings of a firm (FASB). Therefore, the

decision making behaviour of different parties can be impacted as a result of SFAS No. 150,

which might have an influence on the value of a firm. The content of SFAS No. 150 will be

discussed in the literature study. To conclude, the described definitions are all applicable to

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SFAS No. 150. It is impossible to link one single definition of economic consequences to

SFAS No. 150.

There is sufficient evidence to state that accounting regulations have an economic

impact on different parties (Deegan and Unerman, 2005, p. 69). The economic impact of

accounting standards is reflected in the actual behaviour of organizations (Hoogendoorn, et

al., 2007, p. 39). In accordance with the definitions of economic consequences above, the

economic impact is broader than merely the changes in the behaviour of management (i.e.

organizations). Many other parties are involved in the reporting process, such as investors

(e.g. revaluation of the firm (as discussed by Scott, 2003) by common stockholders on the

stock exchange), creditors (e.g. formal contracts as discussed by Holthausen and Leftwich,

1983), et cetera.

The introduction of SFAS No. 150 might have an impact on actual trade decisions of

common stockholders. Common stockholders might sell their stocks or require a higher rate

of return as a result of an increased debt to equity ratio, which can have an influence on debt

covenants, which can lead to an increasing of the investment risk for common stockholders.

The description above of Deegan & Unerman and Hoogendoorn shows that standard

setters should carefully consider the economic consequences of amendments to existing

standards and the introduction of new standards. Beaver (1973) notes about this: “without a

knowledge of consequences…it is inconceivable that a policy-making body…will be able to

select optimal financial accounting standards”. It is necessary that in the standard setting

process all costs and benefits are considered, not merely those directly related to the reporting

firms.

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3.2 Equity theories The discussion on how to classify MRPS is still going on. The debate focuses

mainly on what characteristics can be attributed to equity and liabilities. In this paragraph

theories to determine equity and liabilities are discussed. “Theories of equity postulate how

the balance sheet elements are related and have implications for the definitions of both

liabilities and equity” (Alver, 2006). In general, there are three theories of equity which are

used into new (international) accounting standards, such as SFAS and IFRS (International

Financial Reporting Standards).

Alver (2006) describes the current situation in classifying preferred stocks and

discusses the three related theories. The theories of equity are the Entity theory, the

Proprietary theory and the Residual equity theory. Each theory will be explained below.

3.2.1 Entity Theory

In the past (approximately between 1920 and 1980) American literature has addressed

the issue of whether to continue the sharp distinction between liabilities and equity (Clark,

1993). Paton has developed the Entity Theory in 1922 and this theory “is cited as a potential

basis for recasting the balance sheet” (Clark, 1993). The Entity Theory describes the firm and

the owners as a separate part. This theory can be equated as follows:

According to Alver (2006), the main characteristic of the Entity Theory is that

creditors as well as stockholders allocate resources to the firm. Those two cannot be divided

in liabilities and equity. Both creditors and stockholders are investors of the firms’ assets. All

elements on the credit-side of the balance sheet are claims against the firms’ assets. If this

theory would be leading, debt to equity ratios are not relevant information.

3.2.2 Proprietary Theory

“Present accounting practice presumes that the amount of debt relative to equity is

relevant in assessing firm value” (Clark, 1993). The relevance of the debt to equity ratio is

confirmed in studies (Modigliani & Miller, 1963; Kraus & Litzenberger, 1973; Rubinstein,

1973; Scott, 1975; Givoly, et al., 1992; et cetera) based on the ‘decision usefulness model’,

which assumes that accounting reports are used for decision making. The FASB supports this

view in Concept Statement No. 1. This statement describes that “accountants have an

Assets = Equities (including liabilities)

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obligation to disclose the nature of the elements of a firm’s capital structure in a manner that

allows users to assess how debt and equity instruments will impact the ability and distribution

of firm resources and thereby enable them to evaluate the impact of risk and uncertainty on

firm value” (Clark, 1993).

The Proprietary theory is based on the assumption that the entity is closely connected

with the owner (however, private equity remains separate from the entity). As a result of this

assumption financial statements primarily focus on the firms’ owners. Liabilities are their

obligation and equity is equal to the net worth of the owners. The equation of equity is as

follows:

Current accounting practices are largely based on the Proprietary theory (Alver, 2006).

There are two forms of this theory: firstly, only common stockholders are part of the

proprietary group and preferred stockholders are excluded (also called the ‘narrow form’).

Secondly, both common stock and preferred stock are included in the proprietor’s equity (also

called the ‘broad form’). In conclusion the preferred stockholders cannot be explicitly

included in the firms’ equity. However, with the introduction of SFAS No. 150 the FASB

decides to exclude MRPS from equity, which tends to the first form (‘narrow form’).

On November 30th, 2007 the FASB has issued a Preliminary View document that

proposed a classification system for financial instruments named the Basic Ownership

Approach (BOA) (FASB, 2007). This document is in accordance with the narrow form of the

Proprietary Theory. This shows that according to the theory preferred by the FASB “only the

lowest-level residual interests in an entity qualify for equity classification” (Alver, 2006).

This resembles with the Residual Equity Theory, which is identical to the narrow form of the

Proprietary Theory (Alver, 2006).

3.2.3 Residual Equity Theory

The last theory that is discussed by Alver (2006) is the Residual Equity Theory. In this

theory investors are stockholders and creditors. The residual equity holders are that group of

equity claimants whose rights are superseded by all other claimants (Alver, 2006).

Assets – Liabilities = Equities

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Taking this in account, the accounting equation of assets and equity is depicted as

follows:

Specific equities are the resources put in by creditors and preferred stockholders. The

conclusion to this theory is that preferred stocks are a part of Specific Equities and are equal

to debt holders. Converted into an equation means this:

3.2.4 Relation equity theories with this research

The equity theories are included in this study to determine the underlying concept of

the introduction of SFAS No. 150.

SFAS No. 150 is issued to improve the ‘decision usefulness’ and thereby to make the

difference between equity and liabilities more clear. Apparently, this was necessary for users

of financial statements and shows that financial statement users (apparently) do not depend on

the Entity Theory (FASB 2003).

To give an answer to the research question it is interesting to understand what the

market perception of the economic substance of MRPS is (whether MRPS regarded as

liability or equity), because this affects the risk assessment of common stockholders (Kimmel

& Warfield, 1995). This study is added to the literature review. In the literature review studies

are added that make clear that debt to equity ratio causes a higher risk level within the risk

assessment (market perception) of common stockholders.

Therefore, in the belief of common stockholders there is a distinction between equity

and liabilities (Kimmel & Warfield, 1995), showing that the common stockholders do not

base their decisions on the Entity Theory (described above).

3.3 ConclusionThe introduction of SFAS No. 150 might have an impact on actual trade decisions of

stockholders. They might sell their stocks because of an increased debt to equity ratio, which

can have an influence on debt covenants, which in turn can lead to an increasing of the

investment risk for common stockholders. The impact on the actual trade decisions is a

characteristic of economic consequences.

Assets – Specific Equities (liabilities) = Residual Equity

Assets – liabilities – preferred stocks = Residual Equity

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The discussion on how to classify MRPS is still going on. The debate focuses mainly

on what characteristics can be attributed to equity and liabilities. In this chapter theories to

determine equity and liabilities were discussed. The theories of equity are the Entity theory,

the Proprietary theory and the Residual equity theory. The FASB standards are based on the

narrow form of the Proprietary Theory, which is identical to the Residual Entity Theory.

Finally, a description is given that evaluates the relation between the Equity theories

and the research question. This description shows that common stockholders make a

distinction between liabilities and equity, showing that the common stockholders do not base

their decisions on the Entity Theory. For this very moment, it is interesting what the market

perception is of the economic substance of MRPS (whether MRPS regarded as liability or

equity), because this affects the risk assessment of common stockholders.

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4. Literature study

IntroductionIn this chapter the existing literature about the particular economic consequences of

the introduction of SFAS No. 150 is described. To formulate the hypotheses a review of the

literature is most valuable to this study. Firstly, it is important to check what economic

consequences mean. This has been explained in chapter three. Secondly, previous (empirical)

researches have been found consisting of articles devoted to the topic of this study.

This search has lead to an extensive amount of articles, related to classification issues

of (mandatorily redeemable) preferred stock. These articles focus on the fact that (mandatorily

redeemable) preferred stock have both equity and liability characteristics.

The literature study is divided in six main parts. In each part several articles are

discussed which are connected to the research topic. The first part of the literature review

describes the creation process of SFAS No. 150. After that, the changes in the debt to equity

ratio will be discussed. The third part of the literature review describes the choice of financing

by matter of SFAS No.150. Part four gives a view on the market perception of the economic

substance of MRPS. Thereafter, the relation between leverage and the required rate of return

on common stock will be described. At last, the relation between stock prices and required

rate of return will be described on common stocks. An overview of the used articles is

supplemented in the appendix (see Appendix I: List of used articles).

4.1 Literature study

4.1.1 SFAS No. 150

The topic of this thesis has been chosen as a result of the adoption of SFAS No. 150.

Therefore, the literature review starts with an explanation about the creation process of SFAS

No. 150. SFAS No. 150 has been developed in response to concerns of several groups of users

of financial statements. Users of financial statements are for instance, auditors, regulators and

investors. SFAS No. 150 has been issued to establish standards for how an issuer should

classify and measure certain financial instruments with characteristics of both liabilities and

equity (hybrid instruments).

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Before the issuing of SFAS No. 150 most firms listed their MRPS between the

liabilities section and the equity section (i.e. a ‘mezzanine section’ or ‘quasi-equity’) on the

balance sheet (Schauer, et al. 2006). This is in accordance with the requirements of the

Securities and Exchange Commission (SEC). The SEC (applicable to publicly held firms)

precludes MRPS from the equity-section. On the other hand, the SEC does not require to list

MRPS as a liability.

As a result, most firms classify MRPS in a ‘mezzanine section’ between equity and

liabilities (Nair, et al. 1990). In 1990 the FASB issues a Discussion Memorandum. This

memorandum contains “issues related to the interpretation of the definition of liabilities and

equity in FASB Concepts Statement No. 6 (Elements of Financial Statements), and whether

the distinction between liabilities and equity should be changed” (FASB 2003). The project

with regard to the described issues was inactive until 1996. From that moment the Board’s

Financial Instruments Task Force caught the debate again.

‘The FASB Concepts Statements are intended to serve the public interest by setting

the objectives, qualitative characteristics, and other concepts that guide selection of economic

phenomena to be recognized and measured for financial reporting and their display in

financial statements or related means of communicating information to those who are

interested.’ (FASB). On October 27, 2000, the FASB issues an Exposure Draft of a proposed

Statement of Financial Accounting Standards (No. 150) Accounting for Financial Instruments

with Characteristics of Liabilities, Equity, or Both, and an Exposure Draft of a proposed

amendment to FASB Concepts Statement No. 6, Revise the Definition of Liabilities.

At the end of 2002, “the Board affirmed its conclusions that certain freestanding

financial instruments should be classified as liabilities: mandatorily redeemable

instruments…” (FASB 2003). This is a result of the more stringent definition of liabilities as

given in SFAS No. 6.

19

Statement of Financial Accounting Concepts No. 6 defines liabilities and equity as

follows (Schauer, et al., 2006):

‘Liabilities – probable future sacrifices of economic benefits arising from present

obligations of a particular entity to transfer assets or provide services to other entities

in the future as a result of past transactions or events.’

‘Equities – the residual interest in the assets of an entity that remains after deducting

its liabilities. In a business enterprise the equity is the ownership.’

SFAS No. 150 is issued to improve the ‘decision usefulness’. SFAS No. 150 “will

result in a more complete depiction of an entity’s liabilities and equity and will, thereby, assist

investors and creditors in assessing the amount, timing, and likelihood of potential future cash

outflows and equity share issuances” (FASB 2003). This is in accordance with Concepts

Statement No. 1 (Objectives of Financial Reporting by Business Enterprises) that describes

the ‘decision usefulness’ as an objective of financial reporting.

Furthermore, the statement of SFAS No. 150 is in accordance with the FASB

Concepts Statement No. 2 (Qualitative Characteristics of Accounting Information). FASB

states: ‘The changes in this Statement will enhance the relevance of accounting information

by providing more information about an entity’s obligations to transfer assets or issue shares,

thus, improving its predictive value to users.’ Moreover, in the opinion of the FASB

reliability of accounting information will be improved by providing a good view of a firm’s

capital structure.

Overall, the FASB concluded the benefits of SFAS No. 150 in terms of

improved decision usefulness, relevance and reliability justify the costs.

SFAS No. 150 prescribes that instruments that represent an obligation should

be classified as a liability. MRPS reflects an obligation to deliver assets or issue equity (stock)

to the holder and, therefore, MRPS should be (re)classified as a liability (Schauer, et al.,

2006). This might lead to an increase of firms’ liabilities.

20

In the original pronouncement of SFAS No. 150 “a mandatorily redeemable financial

instrument shall be classified as a liability unless the redemption is required to occur only

upon the liquidation or termination of the reporting entity. A financial instrument issued in the

form of stock is mandatorily redeemable if it embodies an unconditional obligation requiring

the issuer to redeem the instrument by transferring its assets at a specified or determinable

date (or dates) or upon an event certain to occur.” (FASB 2003). Moreover, amounts paid or

to be paid to stockholders of MRPS shall be reflected in interest cost and not as preferred

dividend. This means that the earning of a firm with outstanding MRPS might reduce as a

result of SFAS No. 150. In conclusion, SFAS No. 150 leads to a higher debt to equity ratio

and to a lower level of earning (ceteris paribus).

4.1.2 Changes in the debt to equity ratios

Schauer, et al. (2006) describes the economic consequences of the introduction of

SFAS No. 150. This article is important to this research, because it shows the impact of SFAS

No. 150 on firms which have outstanding MRPS on their balance sheet.

The study uses a year-to-year comparison (2002 to 2003) of debt to equity ratios and,

in addition, a comparison of reported ratios with ratios recalculated as if SFAS No. 150 not is

required. The research outcomes show that the year-to-year debt to equity ratio of affected

firms in the sample is increased with 34 per cent, and the reported ratio (6,9065) in

comparison with the ‘as if SFAS No. 150 not is required’-ratio (4,8296) shows a difference of

43 per cent. The authors of the article make clear that “because the increase directly

associated with the adaptation of SFAS No. 150 is greater than the reported year-to-year

increase; our results suggest that sample firms did take other leverage reducing actions to

lessen the impact of the standard” (Schauer, et al., 2006). The year-to-year increase means the

comparison between the debt to equity ratio of 2002 and 2003.

The study of Schauer, et al. (2006) is very useful to this study; it shows that due to

SFAS No. 150 the debt to equity ratio has changed. However, this study is not about the debt

to equity ratio. But the purpose of this study is to measure a possible effect of announcements

due to SFAS No. 150 that might have had an influence on stock prices.

21

The article of (Maloney & Mulford, 2003) discussed SFAS No. 150 – Accounting for

Certain Financial Instruments with Characteristics of Both Liabilities and Equity. More

precisely,” this report highlights the provision of SFAS No. 150 and the impact it will have on

selected firms’ financial statements” (Maloney & Mulford, 2003). The researchers have

shown an increasing of the debt to equity ratio due to SFAS No. 150 on firms which held

MRPS. The formula which has been used to measure a change in the debt to equity ratio can

be written as (Maloney & Mulford, 2003):

This ratio has been calculated before and after reclassification of MRPS to the

liabilities section of the balance sheet per 2003. The sample which is used concerns fifteen

firms. Twelve of these firms included the MRPS in the ‘mezzanine section’ of the balance

sheet. The researchers showed an increasing of the debt to equity ratio due to the

reclassification of the MRPS. Before the introduction of SFAS No. 150 the ‘mezzanine

section’ of the balance did not affect the debt to equity ratio. Furthermore, two firms included

the MRPS in the ‘mezzanine section’ as well but explained in the footnotes to the financial

statements that a different amount than the amount shown on the balance sheet will be

reclassified. The results for these two firms show an increasing of the debt to equity ratio.

Finally, one firm has been researched that included the MRPS in the equity section of

the balance sheet. To summarize, the value of the equity, the value of the ‘mezzanine section’

and the value of liabilities of these firms changed due to the reclassification of MRPS. This

leads to a change of the debt to equity ratio.

Overall, several researchers have shown that firms’ debt to equity ratio has increased

as a result of SFAS No. 150. Both financial reporting statements require that most of the

hybrid instruments have to be classified as liabilities. This might have an influence on

decisions of stockholders.

total liabilities / total shareholders’ equity

22

4.1.3 The impact of SFAS No. 150 focuses on financing matters

Levi and Segal, 2006 investigated the influence of SFAS No. 150 had on firms’

decisions to finance their operations with MRPS. They found that firms’ financing mixes

declined with 42 per cent as a result of SFAS No. 150. The drop cannot be explained by the

decline in interest rates or changes in equity market conditions over the research period. A

multivariate analysis indicates this statement. This study shows that the non-debt

classification of MRPS before the introduction of SFAS No. 150 motivated managers to use

MRPS. Therefore, reporting classification of financing instruments is an element in managers’

financing decisions. In conclusion, ‘firms prefer to classify new financing as equity in order to

avoid the violation of debt covenants and to meet the capital requirements specified in

operating contracts.’ (Levi and Segal, 2006) This study is in accordance to the finding earlier

presented by Engel (1999) et al. They found evidence that there may be reporting motives

behind managers’ decisions to structure MRPS financing deals. They discovered 44 firms that

issued MRPS (trust preferred stock) and used them to go on to redeem debt. Hereby, a firm

will have fewer obligations listed in the liability section of the balance. Moreover, evidence

shows those investment analysts are influenced by the initial balance sheet classification of

MRPS provided by firms (Hopkins, 1996). Hopkins notes: ‘in an equity valuation task,

analysts treated mandatorily redeemable preferred stock (MRPS) differently depending on

how it was classified.’ For example, when reported as a liability, the analysts treated the

MRPS as a liability in their valuation analysis whereas when reported as a mezzanine item,

analysts were more likely to think about the nature of MRPS, and their decisions depended on

their assumptions about specific features of the MRPS. Prior to SFAS No. 150 a hybrid

financial instrument is disclosed in the mezzanine section then the users of financial reports

can disregard the way firms classify for example a MRPS. An advantage of the mezzanine

section is that equity and credit analysts can reclassify the hybrid financial instrument into the

equity or liability category according to the purpose of their analysis and the characteristics of

the hybrid financial instrument, regardless of its classification by the firm.

4.1.4 Market perception of the economic substance of MRPS

To give an answer to the research question, investigation whether the FASB

requirements are consistent with the market perception of the economic substance of MRPS is

necessary. The usefulness of financial reporting depends in part on the representational

faithfulness of the reporting treatment to the economic substance of the underlying

phenomenon (Statement of Financial Accounting Concepts 2). The FASB has been working

23

on a project to develop representationally faithful classification of financial instruments issued

by firms which is processed in SFAS No. 150. This means that stockholders on the capital

market might have a perception of whether stockholders regard MRPS as a debt or as equity.

In this subparagraph a number of studies will be discussed which focus on the economic

substance of hybrid instruments.

The study of Gunderson and Swanson (2010) investigated whether financial statement

categorization of trust preferred stock influences its market valuation. Trust preferred stock

(hereafter TPS) is an example of a MRPS. More precisely, TPS is a hybrid of financing with

much of the flexibility of equity while also allowing the sponsoring corporation the tax

benefit of interest deductions. This study empirically tests whether the balance sheet

categorisation affects market valuation of trust preferred stock. They examine whether the

effects found by Hopkins (1996) (valuation analysis) also reflected in market prices. A sample

was used of 105 firms –year observations from 2001 – 2004. This study excluded banks and

utilities to avoid regulatory issues and to keep the manual data collection task manageable.

One of the conclusions of this study is that TPS is not priced like a liability or equity. This

statement is in accordance with the placement of TPS in the mezzanine section prior to SFAS

No. 150. More precisely, this study suggests that TPS when reported in the mezzanine

section, investors tend to evaluate the specifics of the instrument. Examples of specifics are

length of maturity, availability terms and degree of subordination. The study of Gunderson

and Swanson (2010) found evidence that financial statement users depend on balances sheet

categories. Moreover, they stated that additional heterogeneity in the liability section may

lead to confusion and miss-interpretation. They state ‘increasing the heterogeneity of the

liability category will be costly if users draw inappropriate conclusions by assuming items

reported as liabilities are similar when in fact they are not.’ In conclusion, this study preaches

the usefulness of the mezzanine section.

Kimmel and Warfield (1995) focus on redeemable preferred stocks (RPFD hereafter).

Kimmel and Warfield (1995) provide empirical evidence on the economic substance of this

kind of stock. The market perception of stockholders is measured using CAPM. Stock prices

must be collected to fulfill CAPM.

The study uses the relation between systematic risk (market risk) and the debt to

equity ratio (leverage) to assess the investors’ perception on the economic substance of

RPFD’s, and as a result, whether they have an equity-like impact or a debt-like impact on the

systematic risk of a firm. Assumed is that a higher leverage causes a higher systematic risk.

24

This relation will be further discussed in articles which are included in this chapter (Hamada,

1972; Bowman, 1979; Hill & Stone, 1980).

Systematic risk (ß or beta) of a firm can be explained as: the measure of how the

changes in the returns to a firm’ stock is related to the changes in returns to the market/branch

as a whole.

The leverage (debt to equity ratio) of a firm is an important figure, because it is

“directly related to the risk associated with investing in the firm’s stock” (Schauer, et al.,

2006). Within CAPM, an increased level of borrowing in combination with a stable amount of

equity causes an increase in the risk for the investor. Therefore, within CAPM and -ceteris

paribus- the systematic risk (depicted as ß) should be greater for the stock of a firm with a

higher debt to equity ratio than for the stocks of another firm with a lower debt to equity ratio

(Hamada, 1972).

Kimmel and Warfield (1995) state that a firms “systematic sensitivity to changes in the

market rate of return is captured by the common stock bèta”. The common stock bèta is

depicted as:

Where:Rit = return on common stock of firm iRMt = return on the market portfolio

The value of a firm equals to the sum of the common stock value and other claims on

the firm’s assets (e.g. debts and bonds). “The overall risk of the firm can be expressed as a

weighted average of the bèta’s of these claims”:

Where:βo = operating riskβd = bèta for debtβs = bèta for common stockD = market value of debtE = market value of equityV = total value of the firm

βsi = cov (Rit, RMt) / var (RMt) (1)

βo = (D/V) βd + (E/V) βs (2)

25

The systematic risk of common stock is the result of operating risk and financial risk

(leverage). Examples of operating risks are credit risk, interest rate risk and market risk

(Moosa, 2007). Leverage can be measured by the debt to equity ratio. Kimmel and Warfield

(1995) depict the systematic risk as:

Kimmel & Warfield (1995) consider the effect of RPFD on the systematic risk of a

firm as follows:

Where:R = market value of RPFDβr = bèta for RPFD

In the light of the study of Kimmel & Warfield (1995), it is interesting to focus on βr.

If RPFD affects the financial risk similar to debt, then βr = βd. On the other hand, if RPFD is

regarded as equity (considering the influence on the risk level of the firm), then βo - βr should

be > 0.

Kimmel & Warfield (1995) have estimated the systematic risk using market model

regressions of weekly firm returns and weekly “value-weighted market portfolio returns”.

Additionally, they use the model of Dhaliwal (1986) to estimate the operating risk. Dhaliwal

(1986) use an accounting beta proxy and estimate from a regression of the earnings of the

firms and the market earnings. Kimmel & Warfield (1995) a natural log of operating risk “to

mitigate the potential impact of the skewed nature of the distribution for this variable”. The

amounts of debts, equity and RPFD are retrieved from Compustat (at the year-end).

The investigation of Kimmel & Warfield (1995) shows that RPFD’s do not have a

debt-like impact on the systematic risk of a firm, which is remarkable given that these stocks

have mandatorily redemption features. The study also devotes attention to other features of

RPFD’s, such as convertibility to common stock and voting rights. The results have shown

that the market perception of the systematic risk of RPFD’s with voting and conversion rights

is equal to equity. Kimmel & Warfield (1995) state about these observations that “these

results suggest that the ability to omit redemption payments during periods of financial

distress combined with control and conversion features result in some RPFD that exhibit a

βs = βo + D/E (βo - βd) (3)

βs = βo + D/E (βo - βd) + R/E (βo - βr) (4)

26

relation with systematic risk similar to that of equity, while the relation for RPFD without

these characteristics does not resemble that of either debt or equity”.

In response to the above, it can be concluded that the market perception of the

economic substance of mandatorily redeemable preferred stock is not consistent with the

FASB requirements to classify RPFD’s (with or without conversion and voting rights) as

liabilities, because RPFD’s without the called features do not have a debt-like impact and

RPFD’s with the called features have an equity-like impact on the systematic risk of a firm.

Another study of Cheng et al. (2003) examines the economic substance of a broad

range of securities by looking into their association with systematic risk and prices. They used

a sample of 2617 firms that reported minority interest or preferred stock during 1993 till 1997.

The researchers of this article state: ‘The conflicting implications of the features of various

corporate claims suggest that a simple classification of preferred stock or other hybrid

securities as either debt or equity based on the conceptual framework definitions is unlikely to

result in useful classification.’ The researches doubt about the classification within a

dichotomous framework what may result in misclassification of hybrid financial instruments.

To examine the economic substance a systematic risk analysis is performed. The research of

Cheng et al, is broader compare to Kimmel and Warfield (1995). Kimmel and Warfield

(1995) have used the systematic risk framework focussed only on the economic substance of

RPFD’s. The study of Cheng et al. (2003) focuses on other claims (e.g. preferred stock, TPS

and minority interest). The framework has been explained above.

The results indicate that redeemable preferred stock is not considered by the market as

either debt or equity. Therefore, the current treatment (SFAS No. 150) of this stock comes not

along with the market treatment. As a result of SFAS No. 150 preferred stock must be

classified as liability. The researches of this study suggest that if a dichotomous framework is

retained, the equity classification should be comprised of only common stock and minority

interests. If the FASB would adapt this advice, disclosures may be more important for

communicating the features relevant to the economic substance of MRPS. As a result of

SFAS No. 150 the usefulness of classification is reduced, because financial instruments

within a category like preferred stock are not similar in their economic substance (Cheng et

al., 2003, Gunderson and Swanson, 2010). Therefore, this study is in accordance to the study

of Gunderson and Swanson (2010) and Kimmel & Warfield (2003).

27

4.1.5 The relation between leverage and the required rate of return on common stock

To provide a more solid basis to this study, empirical articles have been found about

the relation between the systematic risk of a firm and its leverage. The first article that will be

discussed is a study of Hamada (1972). Hamada proves that the debt to equity ratio (as a

result of the capital structure) has a significant effect on the systematic risk (ß). He states that

-ceteris paribus- ß “should be greater for the stock of a firm with a higher debt-equity ratio

than for the stock of another firm in the same risk-class with a lower debt-equity ratio”

(Hamada, 1972). This is of course interesting in the light of this study, because within the

CAPM-model larger ß cause a higher required rate of return on an investment. The relation

between the rate of return and the stock prices will be discussed in the next paragraph.

Hamada (1972) compares the observed rate of return of a (common) stock with the

revised rate of return by stating (“what it would have been over the same time period when

the firm had no debt and preferred shares in its capital structure”). The difference between the

observed systematic risk and the revised rate of return “can be attributed to leverage” Hamada

(1972).

In his report, Hamada (1972) assumes the following relationship for the dividend to

common stockholders (from period t -1 to t 1):

Where: X = earnings before taxes, interest and preferred dividendsIt = interest and other fixed charges τ = corporation income taxpt = preferred dividendΔGt = change in capital growth over the perioddt = dividends to common stockholderscgt = capital gains during the period

Hamada (1972) depict the systematic risk of a common stock as follows:

Where:RBt = rate of return on the common stockRMt = rate of return on the market portfoliocov = covariance between RBt and RMt

σ2 = standard deviation

(X - I)t(1- τ)t - pt+ΔGt = dt+cgt (1)

Bβ = cov (RBt, RMt) / σ2(RMt) (2)

28

Substitution of (1) and (2) leads to:

Where:SBt-1 = market value of the common stock at the beginning of the period

Thereafter, Hamada (1972) considers the same firm “if there were no debt and

preferred stock in its capital structure”. In this situation the systematic risk is depicted as:

Where:RAt = rate of return on the common stock if the firm had no debt and preferred

stockSAt-1 = market value of the common stock at the beginning of the period if the firm

had no debt and preferred stock

SAt-1 is unobservable in fact of these firms have actually debt and preferred stock.

Therefore, Hamada uses a theory (Modigliani & Miller, 1963) to derive this market value.

This theory determines the market value of a firm that had no debt and preferred stock as:

Where:τD = corporation income tax (“tax subsidy for debt financing”)D = market value of debt V t-1 = observed market value

Hamada subtracts D from V to obtain the market value of an unleveraged firm.

Aβ = cov [(X - I)t(1- τ)t - pt+ΔGt / SBt-1 , RMt] / σ2(RMt) (3)

Aβ = cov (RAt, RMt) / σ2(RMt) (4)

= Aβ= cov [X(1- τ)t + ΔGt / SAt-1 , RMt] / σ2(RMt)

SAt-1 = (V – τD)t-1 (5)

29

As mentioned above, SAt-1 is not observable. Therefore, Hamada uses the Modigliani &

Miller, 1963 theory once again to obtain the rate of return on the common stock of the

unlevered firm. Hamada shows this as:

The rate of return of the levered firm (B) can be observed. The rate of return is:

Hamada (1972) remarks that, if leverage is not important, the systematic risk of firm A

(unlevered) should be equal to the systematic risk of firm B (levered). This leads to: Aβ = Bβ

Hamada (1972) uses CRSP and Compustat data for (6) and (7). RAt and RBt (from 1948

to 1967) of 304 firms were derived. For each firm, the regression analyses below were run:

Where:RMt = observed NYSE stock market returnαi = intercept (constant)βi = slope (constant)εit = disturbance term

Hamada uses in (10) and (11) the “continuously-compounded” rate of return versions

of (8) and (9). Within the (10) and (11) formulas, adjustments (logs) were made to eliminate

strong fluctuations of the rate of return over time.

RAt = [dt + cgt + pt + It(1 – τ)t] / (V – τD)t-1 (6)

RBt = [(X – I)t(1 - τ)t – pt + ΔGt] / SBt-1 (7)

RAt = Aαi + Aβi RMt + Aεit (8)RBt = Bαi + Bβi RMt + Bεit (9)Ln(1 + RAit) = ACαi + ACβi ln(1 + RMt) + ACεit (10)Ln(1 + RBit) = BCαi + BCβi ln(1 + RMt) + BCεit (11)

i = 1, 2, …, 304t = 1948-1967

30

The results of Hamada’s investigation showed:

Bβ > Aβ, i.e. 0.9190 > 0.7030

The study referred to above is important for this research as a result of the impact that

the leverage (i.e. capital structure) has on the ß (systematic risk). Leverage explains 21 to 24

percent of the value of the mean ß (systematic risk), averaged over 304 firms. Hamada (1972)

states that this per cent of the systematic risk: “can be merely explained by the added financial

risk taken on by the underlying firm with its use of debt and preferred stock”. In other words,

“corporate leverage does count considerably” (Hamada 1972).

In the light of this research question, the outcomes of Hamada’s investigation reports

that the classification of MRPS as equity or liability is important in fact of the systematic risk

which is impacted as a result of the introduction of the reclassification of MRPS due to SFAS

No. 150.

Hamada’s research about the relation between leverage and systematic risk is

supported by research of Bowman (1979), who has written an article about ‘the theoretical

relationship between systematic risk and financial (accounting) variables’. So the purpose of

that paper is to provide a theoretical basis for empirical research to the relationship between

systematic risk and financial (accounting) variables. The model which has been used is

CAPM. Bowman proves that there is a relation between systematic risk and the firms

leverage. This study confirmed the empirical study of Hamada (1972) with theoretical

evidence.

The formulas which have been used by Bowman are not discussed in detail. Because

Bowman’s research is complete different to this research. The research of Bowman gives

theoretical support for the relation between systematic risk and leverage of a firm. This thesis

is focused on measuring possible effect of announcements about SFAS No. 150 that might

have an influence on stock prices.

The study of Hill & Stone (1980) confirmed empirically the relation between financial

structure of a firm and the systematic risk with empirical evidence. Therefore, Hill & Stone

are supporting the earlier conclusion of Hamada (1972) about the relation between systematic

risk and leverage. This study has used the same variables as the theoretical study of Bowman

(1979). This study used data of 150 firms from the beginning of 1947 until the end of 1974.

The period is divided into two sub periods of both fourteen years. The researchers preformed

31

two correlation tests. This research has given empirical evidence that “changes in financial

structure are significant determinants of period to period changes in the market bèta’s” (Hill

& Stone, 1980). This study is important to this research, because it gives empirical evidence

of the relation between leverage and systematic risk. The formulas and analyses which have

been used by Hill & Stone (1980) are not discussed in detail, because this research is a

completely different one compared to this study.

4.1.6 Relation between stock prices and required return of common stock

To give an answer to the research question the relation between stock prices and

required return of common stock needs to be confirmed. The article of Campbell (2009)

proves this relation. Campbell explores the economic origins of common stock for value and

growth stocks. Campbell notes: ‘stocks will tend to rise together when the market discount

rate (required rate of return) declines, and fall together when the market discount rate

(required rate of return) increases.’ This statement is been argued with previous research by:

Cornell, 1999; Dechow, Sloan & Soliman, 2004; Lettau & Wachter, 2007.

The methodology of this article is not discussed, because the mythology is not

important to this research. The CAPM has been used to measure the required return of

common stock. The other formulas and models are not discussed because this research is

completely different when compared to our research. Campbell’s research is a typical finance

study. To conclude, the rate of return can be measured using CAPM through this model the

systematic risk must be determined. The systematic risk depends on the leverage of a firm

(Hamada, 1972). Therefore, we can develop a hypothesis about the impact that SFAS No. 150

might have had on the stock prices.

4.3 Conclusion Firstly, the original pronouncement of SFAS No. 150 is discussed in the literature

review. As a result of SFAS No. 150 MRPS does have to be (re)classified as liabilities. Due to

the reclassification of financial instruments the debt to equity ratio of firms has changed.

(Schauer, et al., 2006, Maloney & Mulford, 2003 and De Jong, 2006) Furthermore, decisions

to finance operations with MRPS declined because of a possible violation of debt covenants

and capital requirements specified in operating contracts. (Levi and Segal, 2006 and Engel

1999 et al.)

The study of Kimmel & Warfield (1995) and Cheng et al. (2003) assessed the

investors’ perception on the economic substance of RPFD’s and other claims (e.g. preferred

32

stock and TPS) whether they have an equity-like impact or a debt-like impact on the

systematic risk of a firm. Kimmel & Warfield (1995) and Cheng et al. (2003) provided

evidence that RPFD’s and preferred stock do not have a debt-like impact on the systematic

risk of a firm. In our literature review three articles have been written about the relation

between required rate of return and leverage (Hamada, 1972; Bowman, 1979; Hill and Stone,

1980). These articles provided evidence for the relation between the leverage of a firm and the

systematic risk of a firm. Campbell (2009), Cornell (1999), Dechow, Sloan & Soliman (2004)

and Lettau and Wachter (2007) noted that stocks will tend to rise together when the required

rate of return declines, and fall together when the market required rate increases.

Therefore, as a result of a change in the debt to equity ratio due to SFAS No.

150 the systematic risk might be affected. The systematic risk may have an influence on the

required rate of return. Finally the required rate of return may have an impact on stock prices.

33

5. Research design

Introduction

In this study, the central research question that needs to be answered is how American

Stock prices of firms with mandatorily redeemable preferred stock react on the

announcements (events) of SFAS No. 150? In this chapter the research design is further

developed. This chapter is divided into three parts. The development of hypotheses based on

previously discussed literature is explained in paragraph 5.1. Thereafter, the method of

research is discussed. The third part of this chapter describes the several announcements

(events) with regard to SFAS No. 150 and the determination of the sample that is used.

5.1 Hypotheses development The announcements (events) of SFAS No.150 might have had an impact on the

systematic risk of a firm with outstanding MRPS as a result of the reclassification. Hereby,

the debt to equity ratio also changed. (–ceteris paribus-). The debt to equity ratio has a link

with the firm’s systematic risk and therefore the required rate of return of a firm. (Hamada,

1972; Bowman, 1979; Hill and Stone, 1980)

To formulate the first hypothesis of this study, the study of Campbell (2009) is used.

Campbell (2009) states that “stocks will tend to rise together when the market discount rate

(required rate of return) declines, and fall together when the market discount rate (required

rate of return) increases”. Therefore, a higher required rate of return causes a decline in stock

prices. SFAS No. 150 might have affected the required rate of return as a result of a changed

debt to equity ratio. Furthermore, in accordance to Gunderson and Swanson (2010), Kimmel

& Warfield (2003) and Cheng et al (2003) investors assessed MRPS on their specifics such as

length of maturity, available terms and degree of subordination. However, the studies of

Gunderson and Swanson (2010), Levi and Segal (2006) and Hopkins (1996) found evidence

that financial statement users depend on balances sheet categories. Moreover, they stated that

additional heterogeneity in the liability section might lead to confusion and misinterpretation.

Therefore, the first hypothesis is formulated as follows:

H1: The stock prices of firms with outstanding MRPS on the market declined, as result of the

announcements of SFAS No. 150.

34

Several announcements with regard to the introduction of SFAS No. 150 are selected.

This study uses the capital market approach which is based on the assumption that equity

markets are semi-strong according to the Efficient Market Hypothesis (Deegan and Unerman,

2006, p. 378). This means that all publicly available information is rapidly reflected into stock

prices in an unbiased manner. Therefore, the second hypothesis is formulated as:

H2: The issue date of SFAS No. 150 shows a stronger stock market reaction compared to the

other selected announcements in accordance to the semi–strong form of to the Efficient

Market Hypothesis.

5.2 Research method The purpose of this study is to research the effect of the announcements (events) on

stock prices due to the reclassification of MRPS. To perform this study an event study method

is used. The first event study is performed by Ray Ball and Philip Brown (1968), and Fama et

al. (1969). Ball and Brown studied the information content of earnings. Fama et al. published

a study about the adjustment of stock prices to new information. Thereafter, many researchers

have performed similar event studies. There are many empirical articles published using the

event study method. In this paragraph a few of these articles are discussed in relation to this

study.

McWilliams and Siegel (1997) explain an event study as: ‘the event study method is a

powerful tool that can help researchers assess the financial impact of changes in corporate

policy.’ Using this method an unexpected event is correlated with an abnormal return. The

abnormal return can be depicted as (MacKinlay,1997):

Wher

e ARit, Rit and E{Rit\Xt) are the abnormal, actual and normal returns respectively for an event

period. To measure the normal return, the linear relation between the market return and the

firm stock return over 120 days prior to the event is examined. The event period itself is not

included to prevent the event from influencing the outcome.

Overall, to perform an event study the data of the names of firms, event dates and

stock prices are necessary.

ARit = Rit –E(Rit│Xt)

35

One of the most useful studies that are used to perform this study is the study of

MCWilliams and Siegel (1997). They provided information about the several event study

methods. Moreover, they assessed whether event studies paid enough attention to theoretical

and research design issues. With the help of this study they realise a framework that can help

to perform an event study. This framework is shown in the table below.

5.2.1 Assumptions of an event study

The confidence of the event study relies on the truly fullness of the abnormal returns

associated with the event. McWilliams and Siegel (1997) formulated the following

assumptions: ’(1) markets are efficient, (2) the events were unanticipated, and (3) there were

no confounding effects during the event window’. First of all, the influence of the Efficient

Market Hypothesis (EMH) is considered. This theory tells us that stock markets were

extremely efficient in reflecting information about individual stocks and about the stock

market as a whole. A lot of researchers share the opinion that when information becomes

public, the news spreads very quickly and is integrated into the prices of stock without delay.

Any financially relevant information that is received by investors will be quickly integrated

into stock prices. ‘Therefore, an announcement (event) is anything that effect in new relevant

information.’(McWilliams and Siegel, 1997) The question that arises is how long such an

event takes place? A period of days needs to be defined over which the impact of the event is

measured. This particular period is called the ‘event window’. MacKinlay, 1997 notes that an

event study contains two days, the day of the announcement and the day after the

36

announcement. In contrast to MacKinlay, McWilliams and Siegel (1997) argued that the

event window must contain the day of the announcement and the day before the

announcements. The latest performed event study of Bowen et al. (2010) uses three days as a

result of a lack of an exact time of the announcement releases. This study uses an event

window of three days in accordance to Bowen et al. (2010).

The second assumption of McWilliams and Siegel (1997) is that the announcements

(events) need to be in publicity and unexpected. The selected events used in this study are

unexpected. Prior research showed that the economic substance of MRPS do not have a debt-

like impact. The conclusion of the studies of Cheng et al. (2003), Gunderson and Swanson

(2010) and Kimmel and Warfield (1995) is important, because it shows that the mezzanine

section of the balance was in accordance to the opinion of decision makers. However, the

FASB decided to classify many financial instruments as a liability and not like a hybrid

financial instrument.

Finally, the third assumption is supported by the claim that a possible effect of an

event comes from the effects of other events. To reduce the confounding risk, the event

windows selected in this research is three days. Therefore, this reduces the effect of

confounding effects.

5.2.2 Method of research

The most widely accepted event study method is the market model (Leftwich, 1980).

Therefore, this method is chosen to perform this study. The chosen events were not selected

randomly, but they were selected before any abnormal performance tests were performed. The

selected events consist of the initial public announcement dates of proposals by the FASB.

The abnormal returns are assumed to reflect the stock market’s reaction to the arrival

of new information. The market model method described by McWilliams and Siegel (1997) is

used. At first, the standard normal return is estimated. The standard normal return

can be depicted as:

To measure the abnormal return the following equation is used:

Rit = ai + βi Rmt + εit

ARit = Rit – (ai + bi Rmt)

37

Where ai and bi are parameter estimates obtained from a regression of Rit on Rmt over a

period of 50 days prior to the event. The abnormal return represents returns earned by the firm

after the deduction of the normal return.

After the calculation of the AR the abnormal return is standardised. The Standardized

Abnormal Return (SAR hereafter) ensures that the results of the event study will not be

attributed to specific causes (Dodd and Warner, 1983). The calculation to measure the SAR of

a firm can be noted as:

The standard deviation can be measured as follows:

Where S2 is the residual variance from the market model as computed for firm I, Rm is

the mean return on the market calculated during the estimation period, and T is the number of

days in the estimation period.

After that for each firm the cumulative abnormal return (CAR) will be determined as

follow:

Where k is the event study. The statistical test to measure if an event is

significantly different from zero can be performed when the average standardized cumulative

abnormal return (ACAR) across all firms is computed.

The ACAR can be calculated as:

SARit = ARit / SDit

SDit = (Si2 * (1+1/T(Rmt – Rm)2/εT(Rmt – Rm)2))0.5

CARi = (1/k0,5)Εk SARit

ACARt = 1/n * 1/(( T – 2) / ( T – 4))0,5 εn CAR it 38

When the ACAR is computed, the Z test can be performed.

The Z test can be depicted as:

The outcome of the Z test will be used to assess whether the ACAR is significantly different from zero.

F –score Furthermore, an F- score is performed to measure whether the issue date shows a

stronger market reaction compared to the other events during the announcements of SFAS

No. 150.

5.3 Event dates

5.3.1 Research period

Before SFAS No. 150 was issued, several announcements took place. These several

announcements have ensured that SFAS No. 150 is introduced. In this paragraph the

important dates with regard to the process of the introduction of SFAS no. 150 are explained.

The first selected date is October, 27, 2000. On this date an exposure draft of a proposed

Statement of Accounting for financial instruments of Characteristics of Liabilities, Equity or

both. On the same day the FASB proposed an Amendment to FASB Concepts Statement No.

6 to Revise the Definition of Liabilities. As a result of both proposals, investors and firms

could have known that some financial instruments will be classified as liability instead of the

mezzanine section of the balance.

The second date which is selected to perform this study is 16th October, 2001. On this

date, 18 constituents participated discussing several issues raised in comment letters on the

Exposure drafts. One of the discussion points was about MRPS. Some of the participants

claimed: ‘that the reclassification of financial instruments from the equity to the liabilities

section as a result of SFAS 150 would wipe the net worth of small companies in his industry,

and harm their ability to attain public projects.’

The third date which is selected is the date of issuing of SFAS No. 150, Accounting for

Certain Financial Instruments with Characteristics of both Liabilities and Equity. This news was

released on May 15, 2003. Investors and firms were able to read the information of the

Z = ACAR t * n0,5

39

consequences this standard would have on the firm they represent or the firm were they invest

their money in.

The last selected date is the effective date of SFAS No. 150. The date that public firms

had to implement SFAS No. 150 was on June 15, 2003.

5.3.2 Sample

To conduct this study two databases have been used to collect the data namely

Compustat and Datastream. In Compustat the firms listed on the S&P 500 with MRPS have

been selected. The stock prices and event dates of the S&P 500 have been collected with the

use of the database Datastream. The results of this research are described in chapter six.

6. Results and analysis

Introduction

40

This section presents the results of the performed empirically research and includes the

analysis of the results. The hypotheses are tested using the market model explained in chapter

five of this thesis. The dataset that is used to carry out this research is given and an answer is

given to the research question: how did the American Stock prices of firms with mandatorily

redeemable preferred stock react to the announcements (events) of SFAS 150? This research

focuses on an event study using daily returns in order to analyze what effect the

announcements might have had on the returns of firms with outstanding MRPS. The four

event dates of the announcements that took place are described in chapter five. The firms

listed on the S&P 500 with outstanding MRPS at the time of the announcements are selected

to carry out this research. The results (whether there is an abnormal return measured) of an

announcement is explained separately.

In this chapter the two hypotheses are tested. At first, the outcome of the empirical

research is described in detail. Secondly, the hypotheses written in chapter five is performed

with the help of the results.

6.1 Descriptive statistics of the sample At first, the number of firms with outstanding MRPS during the four announcements

varied between 29 and 46. The total sample of firms is included in the appendix. The numbers

of firms that have been used along the four announcements are 57 firms.

The differences between the ranges may be the result of the introduction of the

reclassification of MRPS from the mezzanine sector of the balance to the liabilities, because

after the issuing date firms with outstanding MRPS declined to 28 firms. Firms prefer to

finance their investments with equity and not with debt which would have a negative

influence on the debt to equity ratio of a firm.

6.2 Results and analysis of the outcomes

41

6.2.1 The performed Z-test

A Z –test is carried out to determine whether the announcement period’s return with

regard to the reclassification of MRPS through the announcements belonging to SFAS No.

150 is significantly different from the market return at the same period during which the

announcements took place. Therefore, the test statistic used to determine the statistical

significance of the abnormal return arising from the announcements to the reclassification of

MRPS is a Z-test.

To determine the abnormal returns the S&P 500 is used as the market proxy. The

abnormal return of the firms with outstanding MRPS can be measured with the use of the

alpha, betas, standard deviation and the variance of the firms. With the help of these data the

expected return can be measured. Summarized, the abnormal return is the real return minus

the expected return of a firm.

The abnormal returns belonging to the announcement of a board meeting on October

16, 2001 and the effective date on June 15, 2003 (the effective date) are relatively small

compared to the event dates when on October 27, 2000 (the exposure draft published the

results) and May 15, 2003 (the issuing date was announced) The evidence indicates expected

returns significantly smaller than the real return of the portfolio over the comparison period

when announcement occurred.

Table 1 the independent and other explanatory variables are shown.

Statistics Portfolio Return Date 1 Return Date 2 Return Date 3 Return Date 4

Date October 27, 2000 October 16, 2001 May 15, 2003 June 15, 2003Alpha 0,000130724 -0,000338401 0,000515182 0,002339265Beta 0,44355285 0,598653896 1,048818622 0,888521011Standard deviation 0,314041033 0,248406135 0,234603215 0,269793194Variance 0,117648244 0,085674331 0,066352665 0,091934502Number 38 46 29 29         Expected return 0,010859929 -0,007099928 0,005636342 0,020029867Real return 0,045972141 -0,005105036 0,027195099 0,021482921

   Abnormal return 0,035112211 0,001994892 0,021558756 0,001453054

Table two (pg. 44) seems to indicate that investors are reacting to the announcement

with regard to the first and the third announcement of SFAS No. 150. However, all four

announcements have not shown a significant outcome. The Z –tests show results of 0, 40 and

42

0.26 with regard to the first and third event date, with a significance level of 1, 96. The results

of the second and the fourth announcement are either not significant. The performed Z –test

gives a result of 0,098 and 0, 0274 and with a significance level of 1, 96.

Looking at the results with the help of table one, the real returns of the portfolio

during the events were performing better than the expected returns of the portfolio. In

accordance to the theory, the real returns of the portfolio were expected to be lower in relation

to the returns of the expected since the required rate of return should increase as a result of a

modified debt to equity ratio. The theory is discussed in chapter four (literature study) and

chapter five (hypotheses). Following the theories which are used to formulate the hypotheses,

the returns of the portfolio performance during the events connected to SFAS No. 150 were

expected to be less than the returns of the market at that particular moment.

Therefore, there could be other news on these two days (October 27, 2000 (the

exposure draft published the results) and May 15, 2003 (the issuing date was announced))

that influenced returns of the selected firms with outstanding MRPS. For instance, during

March 2000, the S&P 500 faced the dot-com bubble that ended in 2002. After that, the stocks

in the S&P 500 recorded a decline of $5.5 trillion (58%) in market capitalization from 2000 to

20021.

Taking this into account, the performance of stocks decreased dramatically in that

period. The firms with outstanding MRPS have had less to do with this bubble and therefore

performed better than the market as a whole.

In the beginning of 2003, there was a crisis going on in America which influenced the

stock prices of firms listed on the S&P 500. In the same year of 2003, there was a turning

point which started in March. The index raised 100 points in one month and at the end of that

year with 220 points2. Recovery of an economy starts mostly with some particular sectors

followed by other sectors. This could be an explanation for the performance of the stocks with

outstanding MRPS that can be in one of the sectors that recovered most rapidly.

In the next subparagraph more explanation will be given about how to interpret the

results described above.

Table 2 statistics of the four events connected to the market model

1 www.businessweek.com/investor/content/apr2008/pi20080425_706031.htm

2 http://futures.tradingcharts.com/historical/SP/2003/0/continuous.html

43

ACAR Z- toets P- waarde

Event 1 0,064855941 0,399798869 0,655347668

Event 2 0,014469612 0,098137684 0,539088518

Event 3 0,047658003 0,256646202 0,601274047

Event 4 0,005090943 0,027415565 0,510935858

6.2.2 Interpretation of the results

There are three points that are discussed in more detail that could have an impact on

the results described above. Afterwards the results in relation to the formulated hypotheses in

chapter five are discussed further.

First of all, the stock prices are based on the future dividends of a firm. To determine

the stock prices, the expected dividends need to be discounted with the cost of capital that

reflects the risk of the firm. The weighted average cost of capital (WACC) is reflecting the

cost of debt and equity that needs to be paid to the holders of such financial instruments.

Overall, debt has a lower cost of capital than equity. The debt becomes more risky as a result

of the possibility that the firm will default. Therefore, equity cost of capital increases when a

firm increasing the amount of debt (Corporate Finance, J. Berk & P. DeMarzo). The risk

appétit of investors is applicable to this research, because it’s about the level of risk investors

are willing to take. As a result of the reclassification of MRPS investors can adjust the WACC

of a firm with outstanding MRPS. On the other hand, it can be that investors do regard MRPS

neither as liability nor equity. If so, investors will not take actions to demand for a higher

required rate of return. If the risk appétit does not change, it cannot confirm the hypothesis

described in chapter five namely, the stock prices of firms with outstanding MRPS on the

market declined, as a result of the announcements of SFAS No. 150.

Therefore, the risk appétit is not changed through the announcements that occurred

during the development process of the accounting standard SFAS No. 150 with regard to the

sample that is researched.

Another explanation that can be pointed out is the characteristics of MRPS. Investors

could have the conviction that nothing has changed, because of the fact that the characteristics

of MRPS are not adjusted. SFAS No. 150 is only focussed on the reclassification of this

hybrid financial instrument.

The final explanation of the results I would like to mention is about the firms with

outstanding MRPS that can be distinguished to mainly two sectors namely the

telecommunication sector and the energy sector. In the S&P 500 twenty-two energy firms and

44

twelve firms that belong to the telecommunication sector have outstanding MRPS during the

announcements. Therefore, these two sectors are dominated and represent 61% of the dataset

that has been used to carry out this research. Those firms connected to the two sectors cannot

so interested in the reclassification of MRPS. This is because the stockholders that owned

these shares might be very reliable stockholders, for instance government organizations.

Therefore, the risk appétit of investors does not change due to the reclassification of MRPS.

Furthermore, it is impossible to reduce the two sectors of the current dataset and

perform the research without these 35 firms. This would have an effect on the reliability of the

research due to the small dataset that remains.

6.2.3. Results and hypotheses

H1: The stock prices of firms with outstanding MRPS on the market declined, as

result of the announcements of SFAS No. 150.

Regarding to the first hypothesis, no significant relationship is found between the

modifications of the debt to equity ratio and the required rate of return of firms with

outstanding MRPS during the events. Table two demonstrates that no Z- scores reached the

significant level of 1, 96. Therefore, hypothesis one cannot be approved. Instead of that, the

real return performed better during the events (table 1). This is not in accordance to the

studies of Campbell 2009, Hamada, 1972, Bowman, 1979, Hill and Stone, 1980, Gunderson

and Swanson, 2010, Levi and Segal, 2006 and Hopkins, 1996.

H2: The issue date of SFAS No. 150 shows a stronger stock market reaction compared

to the other selected announcements in accordance to the semi–strong form of to the Efficient

Market Hypothesis.

The second hypothesis is empirically supported performing an F -score. Table three

shows a significant level between announcements. The third event is significant to the other

events. The third event was the announcement of the issuing date of SFAS No. 150.

Stockholders can be lightly aware of the consequences of the reclassification of MRPS on the

balance sheet.

Table 3 statistics of the F –score between the four events

F score Event 1 Event 2 Event 3 Event 4Event 1 - 0,825675875 0,000423833 0,662658641

Event 2 - - 0,000161452 0,514025407

Event 3 - - - 0,002548319

45

6.4 Conclusion To conclude, this research finds support for the second hypothesis that the market

reaction was stronger linked to the third event in relation to the rest of the events. The first

hypothesis cannot be approved. No empirically evidence has been found that stock prices

declined significantly to firms with outstanding MRPS listed on the S&P 500 in relation to the

market.

46

7 Conclusion

Introduction

This chapter presents the main conclusions from this study and gives attention to its

limitations and provides recommendations for future research.

7.1 Research conclusion There is still a debate going on about how to distinguish equity from liabilities with

regard to financial instruments with characteristics of even debt and equity. The FASB

decided to classify MRPS as liability to improve the decision usefulness of investors. This

study focuses on whether stockholders regarded MRPS as a liability or as equity. The market

perception of stockholders about the economic substance of MRPS is investigated. The FASB

decided to classify MRPS as liabilities; the market perception of stockholders about MRPS

could be different. The following research question is formulated. (Chapter 2):

How did the American Stock prices of firms with mandatorily redeemable preferred stock

react to the announcements (events) of SFAS No. 150?

Before the empirical research, first the theoretical framework related to the

modification of debt to equity ratio, financing matters, market perception of the economic

substance of MRPS, the leverage of a firm in relation to the systematic risk (beta) of a firm

and the required rate of return and their impact on stock prices is described. Afterwards the

research model is explained to give an answer to the research question. The empirical research

consisted of analyzing 57 firms with outstanding MRPS during the events connected to the

introduction of SFAS No. 150 so to determine whether stockholders react on announcements

connected to the reclassification of MRPS to the liability section of the balance sheet.

This study indicates that the results are not in accordance with the literature that is

used to develop the hypotheses written in chapter five of this thesis. The articles of

Hopkins (1996), Gunderson & Swanson (2010), Hamada (1972) and Campbell (2009) are

used to develop the hypotheses. Hopkins (1996) and Gunderson & Swanson (2010) stated that

users of financial statements depend on their decisions on balance sheet categories.

Furthermore, Hamada (1972) and others noted that there is a relation between leverage and

systematic risk (beta) of a firm. Campbell (2009) and others noticed the relation between

required rate of return and stock prices. The required rate of return can be measured with the

CAPM.

47

The results of this thesis indicate that the economic substance of the FASB is not in

accordance to the economic substance of stockholders with regard to MRPS. No significant

evidence has been found that stockholders react on the announcements to SFAS No. 150. The

results might show that stockholders are able to measure the risk of hybrid instruments like

MRPS without a prescribed financial statement on how to distinguish liabilities and equity.

Therefore, stockholders seem to distinguish MRPS not as debt or equity in accordance to the

research of Kimmel and Warfield (1995), Cheng et al. (2003) and Gunderson and Swanson

(2010). They stated that stockholders do not only look at the classification but also at specifics

like length of maturity, voting rights and degree of subordination of MRPS.

Therefore, as a result of the reclassification of MRPS, stockholders might not change

the required rate of return of firms with outstanding MRPS.

Nevertheless, a lot of firms have declined their outstanding MRPS after the

introduction of SFAS No. 150, which is investigated by research of Levi and Segal (2006) and

Maloney & Mulford (2003).

Moreover, the results indicate that the reclassification of MRPS to the liabilities

section has no significant impact on the systematic risk of a firm, which is inconsistent with

the finding of Hamada (1972), Bowman (1979) and Hill & Stone (1980). The systematic risk

is needed to determine the required rate of return using the CAPM. If the required rate of

return does not modify, the stock prices do not fluctuate - ceteris paribus- .

To give an answer to the research question, no significant evidence has been found

that stockholders react on the announcements to SFAS No. 150. MRPS is a hybrid instrument

and therefore the assessment of this financial instrument might be different than other

financial instruments. However, the issue date of SFAS No. 150 shows a stronger reaction

compared to the other selected announcements. In previous chapters some arguments were

given to explain the results. To summarize, the IT bubble, sectors with significant more

outstanding MRPS than other sectors listed on the S&P 500 and the risk appétit of

stockholders might not change because SFAS No. 150 has influenced the reclassification of

MRPS, but it didn’t change the characteristics of MRPS. Therefore, the economic substance

of MRPS cannot be classified as liability or equity, but it seems to be a hybrid instrument with

characteristics of both liability and equity.

48

7.2 Limitations The important limitations in this study are in its method to analyze the events. In chapter five,

subparagraph 5.2.1 describes several limitations that have to be considered to increase the reliability of

the outcomes. A tested model such as the market model has been used to reduce limitations.

7.3 Recommendations for future research To formulate the hypotheses, research of Hamada (1972), Bowman (1979) and Hill and Stone

(1980) have been used. They proved the relation between leverage and systematic risk (beta). They

noted that debt to equity ratio influences the required rate of a firm throughout a modified systematic

risk. However, this study did not find empirical evidence of a connection between leverage and

required rate of return to the reclassification of MRPS. My recommendation is that more up to date

research can be performed to test whether leverage influences the systematic risk of firms nowadays.

If a change in debt to equity ratio does not affected the required rate of return there will be no stock

price reaction throughout a reclassification. Therefore, it would be interesting to research whether the

researches of Hamada (1972), Bowman (1979) and Hill and Stone (1980) are still relevant nowadays.

49

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Appendix II

Listed of firms with outstanding MRPS during the events

1. XEROX CORP2. WILLIAMS COS INC3. WENDY'S INTERNATIONAL INC4. VF CORP5. US AIRWAYS GROUP INC-OLD6. UNITED TECHNOLOGIES CORP7. SPRINT PCS GROUP8. SPRINT NEXTEL CORP9. SEMPRA ENERGY10. SEALED AIR CORP11. QUAKER OATS CO12. PUBLIC SERVICE ENTRP GRP INC13. PRAXAIR INC14. PPL CORP15. POTLATCH CORP16. PLACER DOME INC17. PG&E CORP18. PEPSICO INC19. OLD KENT FINANCIAL CORP20. NORTHROP GRUMMAN CORP21. NIKE INC22. NICOR INC23. NIAGARA MOHAWK HOLDINGS INC24. NEXTEL COMMUNICATIONS INC25. NCR CORP26. MICRON TECHNOLOGY INC27. MCDONALD'S CORP28. MAY DEPARTMENT STORES CO29. LUCENT TECHNOLOGIES INC30. KIMBERLY-CLARK CORP31. INCO LTD32. HSBC FINANCE CORP33. GPU INC34. GOODRICH CORP35. GILLETTE CO36. FREEPORT-MCMORAN COP&GOLD37. FIRSTENERGY CORP38. EXELON CORP39. ENTERGY CORP40. ENTERASYS NETWORKS INC41. ENERGY FUTURE HOLDINGS CORP42. EDISON INTERNATIONAL43. DYNEGY INC44. DUKE ENERGY CORP45. DILLARDS INC -CL A

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46. DELTA AIR LINES INC47. CUMMINS INC48. CORNING INC49. CONSOLIDATED EDISON INC50. COMCAST CORP51. COMERICA INC52. CITRIX SYSTEMS INC53. AVAYA INC54. AT&T CORP55. AON CORP56. AMERICAN ELECTRIC POWER CO57. ALLIED WASTE INDUSTRIES INC

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