Professional Documents
Culture Documents
of Financial
THE
Economics
8 (1980) 139-178.
0 North-Holland
Publishing
Company
CHANGE
Received
oj Califomiu,
March
W. MASULIS*
Loa
Angeles,
received
February
1980
I. Introduction
Corporate
finance theory has not yet determined
the consequences
of
fragmenting
a firms probability
distribution
of future market value into
classes of securities.
Modigliani- Miller
(1958) demonstrate
that when
production-investment
decisions
are held fixed. the value of a firm is
invariant
to the composition
of its capital structure given a perfect capital
market (frictionless
and perfectly competitive)
and no taxes. Fama-Miller
(1972. pp. 167-170) further demonstrate
that under the added condition
of
complete
protective
covenants
or me-first rules the values of a firms
individual
securities are invariant
to capital structure changes. However, the
*This is based on my Ph.D. disscrtatron
wrrtten at the Universrty of Chicago. I would like to
thank my committee
~ Nicholas Gonedes,
Albert Madansky.
Merton Miller. Harry Roberts,
Myron Scholes, and especially my chanman,
Robert Hamada -~ for therr help and encouragement. I have also benefitted
from the suggestions
of Walter Blum, Stephen Brown. Paul
Cootner, Harry DeAngelo,
Lawrence Fisher, George Foster, Michael Jensen, Roger Ibbotson,
John Long, David Mayers, Wayne Mikkelson, Clifford Smith, G. William Schwert. the referee,
Richard Ruback, and the participants
in the finance workshops
at Chicago, Rochester. UCLA
and elsewhere. This study was partially supported
by the Center for Research in Securrty Prices
at the University of Chicago. The author takes full responsibility
for remaining errors.
In this proof, Modigliani-Miller
assumed that the firms debt was riskless. However, this was
later shown to be only a simplifying assumption;
see Fama-Miller
for risky debt wrth perfect
me-first rules and Fama (1978) for risky debt without perfect me-first rules.
~n~lancc.
a new
outflow.
These
assets
and.
111 general,
exact
moment
structure
changes
Jatusipitak
(1974)
common
stock
impact
debt
of
of
Scholes
common
stocks
199
(1972)
change
the
structure
are
contaminated
studlcd
stock
the
of
24
tender
analyzed
monthly
rates
of
impact
of
the
by
value
asset
recent
structure
debt
of equity
the
fnms
most
asset
subsidiaries
Masulis
stock
is slgmticant
related
on
(1980)
to
daily
rates
of 696
that
the
the
of
rights
in each
the directlon
Issues
of these
An
for
of
Chen-
studied
on
the
and
long
the
announce-
term
earlier
study
by
common
stock
on
studies
leverage
the
capital
companies
stock
impact
return.
of the
Honess
utility
firms
at
of
(1977)
common
studied
the
structure
changes.
23
causes
of
studlcs
Kim~McConnell~C;reenwood
common
It
a rcpurchasc
changes
additional
of announcements
directly
whllc
equal
properties
return;
and
of return.
was
in
Consequently
issuing
financing
on
~nflov.
simultaneous
of
return;
offers
the
return
rates
of
result
change.
by
captive
rates
a ca!,h
flows
distrlbutlonal
impact
residual
residual
announcement
~n~oIbe\
cash
capital
weekly
stock
of debt
the
formation
monthly
ment
of
issue
simultaneous
the
change.
common
announcements
for major security classes. The security returns comprising
these portfolios are futher segregated
by type of exchange offer to isolate
their potential
economic
causes. Section 6 summarizes
the findings and
implications
of this study.
2. Review of corporate finance theory
Major theories
of capital
structure
hypothesize
two valuation
effects
arising from capital structure change: a corporate tax effect and an expected
cost of bankruptcy
effect. Changes in a firms after tax value predicted by
these theories imply like directional
changes in the values of the firms
individual risky securities.
tax deductible
interest payments
In a world with corporate
taxation,
subsidize the issuance of debt [Modigliani
Miller (1963)]. Increasing
outstanding
debt increases a firms tax shield; this in turn increases a firms
value by the amount of the tax shield capitalized
over its life multiplied
by
the corporate tax rate. With the introduction
of differential personal taxation
across investors, where debt interest income is taxed at a higher rate than
capital
gains income
derived
from stock, the earlier Modigliani- Miller
conclusion
is no longer definitive. In this case, corporate tax deductions
are
at least partially offset by additional
personal tax liabilities of the acquiring
debtholders.
Miller (1976) shows that for equilibrium
to exist in a perfect
capital market with corporate and differential personal income tax rates, debt
policy can have no effect on firm market value. In this case, a given firm
should be indifferent
to the level of outstanding
debt since there is no
optimal level of debt for the firm (though there is an optimal aggregate level
of debt).
With the introduction
of investment
tax shields or leverage related cost,
DeAngelo-Masulis
(1979) demcnstrate
that the existence of a personal tax
bias against debt income diminishes but does not eliminate the net corporate
tax benefit of debt.4 Moreover, a unique optimal capital structure will often
exist in this tax environment,
where at the margin,
the corporate
tax
advantage
of debt exactly offsets the personal tax disadvantage
of holding
debt. Given the conflicting predictions of these competing theories. resolution
of this controversy
requires empirical evidence.
For a descrqtion
of the assumed relationship
between the firm value and the values of risky
debt and equity. see Black-Scholes
(1973) and Merton (1974), and for the relatmnshlp
between
firm value and the value of preferred stock. see Merton (1974).
A somewhat
different argument
IS made by Kraus-Litzenberger
(1973). Brennan Schwartz
(1978) and Kim (1977) who link the usefulness of the debt tax shield to the probability
of
solvency. Their models also imply that the present value of the debt tax shield increases at a
decreasing rate since the probability
of bankruptcy
IS rismg with the increase in debt.
142
2.2. Expected
R. W Masulis,
EfJects
costs of bunkruptcy
of exrhange
und reorganization
R.W Musulis,
Effects
of exchungeoferson
security prices
r43
2.3. Weulth
redistributions
and incomplete
protective
couencmts
R.W Maw/is,
Eflecrs oJ exchunge
ofers
on security prices
145
announcement
prices are made better off at the expense of the outstanding
debtholders.
Due to explicit and/or
implicit limitations
in protective
covenants, the debtholders
now bear greater risk of default but receive the
same interest payments from the firm. Preferred stockholders
who do not or
cannot convert their preferred stock to debt are hurt because claims of equal
standing
are elevated to senior standing,
thereby increasing
the preferred
stocks risk of 10~s.~
If corporate
tax and/or bankruptcy
cost effects exist, a change in capital
structure can cause a change in the firms investment
decisions that change
the firms rate of return variance inducing a secondary redistribution
effect.
When the firms variance is decreased the senior non-convertible
debt and
preferred stock increase in value while thecommon stock, warrants and conversion
feature ofdebt and preferred stock decrease in value (and vice versa for a decrease in
variance). This secondary redistribution
of wealth can reinforce or reduce the
primary redistribution
of wealth discussed previously. Given the far-ranging
implications of this redistribution
of wealth hypothesis for the effects of corporate
financing decisions on the values of firm securities, it is important to determine its
empirical validity and level of significance.
2.4. SummurJ,
of throrrticul
predictions
Table 1 summarizes
the predicted effects of capital structure change given
by the three hypotheses:
interest deductibility
under corporate
taxation.
expected costs of bankruptcy
and reorganization
and wealth redistributions
under incomplete
protective
covenants.
Observed
security
price changes
can reflect the impacts of all three hypotheses.
There are three categories
of capital
structure
change
shown:
exchanges
of debt for outstanding
common stock, exchanges of preferred stock for outstanding
common stock
and exchanges
of debt for outstanding
preferred
stock. The qualitative
predictions of the three hypotheses are given for the change in market values
of each major class of firm securities. It is assumed in each case that the
senior security is being issued to retire the junior security. It is important
to note that when firm debt is increased the predictions
of the corporate tax
hypothesis
are opposite
from those of the expected cost of bankruptcy
hypothesis. On the other hand, while these two hypotheses individually
make
lJUnder
ImplicIt covenant
llmltatlons
common stockholders
can be hurt to a small extent.
because in an Involuntary
reorganization
common stockholders
can still receive some payment
from the lirm but the sire of this payment 15 diminished as the preferred stock IS converted mto
higher priority debt claims.
The debt and preferred stock on table I are assumed to be noncon\ertlblr
securities. If this
were not the case, the security would experience
not only the effects of otherwise
similar
nonconvertible
securities but also the effects experienced
by the common stock into which the
security is convertible.
tax. bankruptcy
Positive
Positive
Preferred
stock
Risky
debt
Negative
Negative
Negative
Positivje
Negative
Negative
Redistributron
Bankruptcy
cost
Table
None
None
None
Corporate
tax
Preferred
structure
clawhed
None
None
None
None or
negative
Negative
Positive
Redrstribution
classes
classified
Positive
Positive
Positive
Corporate
tax
Negatwe
Positive
None or
negative
Negative
Negative
Negative
Redistribution
by type of exchange
Bankruptcy
cost
security
Bankruptcy
cost
for common
changes
Capital
Posrtive
Common
stock
Corporate
tax
corporate
Change rn
market value
of existing
security
classes
Predrcted
uniform qualitative
predictions
for the values of each of the firms major
classes of securities,
this is not the case for the predictions
of the redistribution
of wealth hypothesis.
The differential
predictions
described in
table 1 are important for the interpretation
of the empirical results.
2.5.
Prdictions
of other
theories
Although there is no limit to the number of theories which predict effects due
to capital structure changes, at least two other recently developed theories
have interested
financial
theorists. The first theory posits that managers,
motivated to communicate
insider information
concerning
firm value to the
public, undertake
costly capital structure
changes that act as validated
signals of this information
[Ross (1977) and Leland-Pyle
(1977)]. It is
suggested that firms signal an increase in firm asset \,alue by increasing
leverage in Leland Pyle. Howecer,
leverage in Ross, and by decreasing
neither of these models specifies the new information
that management
is
releasing concerning
firm asset value, making separation
of this signalling
effect from other hypothesized
effects of capital structure change difficult. As
a consequence.
the signalling hypothesis will not be formally tested.
Other types of information
effects are also possible. For instance,
the
agency cost model predicts that a firms capital structure affects management
incentives
to make particular
firm related decisions.
Consequently,
the
likelihood
of future capital structure
and asset structure
decisions will be
altered in predictable
directions given a current change in capital structure.
This is an information
effect quite separate from the effect predicted by the
Ross model which also could affect security
price adjustments.
Other
information
effects are also conceivable.
A second alternative
hypothesis
explaining
the observed security price
effects of exchange offer announcements
is the offer premium hypothesis. An
exchange
offer premium
is defined as the difference
between
the preannouncement
market price of the security being retired minus the postannouncement
market value of the securities being offered in exchange. The
hypothesis presumes that the price of the security being purchased by means
of an exchange offer must rise by the amount of the exchange offer premium
to ensure a continuance
of secondary
market trading. This requires that
some securityholders
must be indifferent to tendering to the firm or selling in
the secondary
market. It is implicitly
assumed under this hypothesis
that
there is an upward sloping supply curve for the security being tendered,
possibly due to heterogeneous
capital gains liabilities. It follows that while
some securityholders
will prefer to tender, others will not. As a result, there
will be an intra-security
class redistribution
of wealth to those securityholders tendering from those securityholders
not tendering. Furthermore,
at the
end of the offer period, the securitys price should fall by more than the
3. Description
directors
is then submitted
to those securityholders
who will be directly
affected by the changes. The plan of recapitalization,
which requires the
approval of a majority of each affected security class, generally requires that
all holders of the class of securities being retired accept the exchange of
offer will include
securities.
From
this point
on, the term exchange
recapitalizations.
a
3.2. Tux consequences
of
exchunge
oglers
a significant
price
discount.
Just
the
opposite
effect
occurs
under
an
Recapitahzations comprise a relatively small portion of ON sample (23 events out of a total
sample of 163 events).
See Bittker Eustice (1971) for a more thorough discusslon of the tax questlons covered here.
See Section 368(a) (I) of the Internal Revenue Code.
If. after tendering
shares, the investor holds X0 percent or more of the firms shares and
voting control which he initially held. this repurchase may be treated as a cash dividend under
Section
Revenue Code.
150
R.19:
Masulis,
Effects
of exchangec~ffeers
on security prices
little or no capital
gains liability
on
offer process
offer unnouncements
and, in most
The following sample selection criteria were imposed in order to limit the
observable price effects solely to the announcement
of exchange offers and to
confine the sample to those events having reliable data sources:
(1) Only
stock outstanding
one major class of firm
associated
with the exchange offer
(3) Cash and other asset distributions
were limited to a maximum
of 25 percent of the value of the affected
securities being tendered in the offer.
of other major asset structure
or capital
(4) Firms with announcements
structure
changes
which were made within one week prior to or
following the initial offer announcement
were excluded.5
Of the 188 offers initially found to meet the first two criteria, 163 remained
after the entire screening process. Even after passing this screening process,
the offer must still be considered
an trppr-oxinnrtiorl
to a pure capital
structure change because claims to fractional
shares of new securities were
paid in cash, some offers involve small cash distributions
and there are
transaction
costs of making the offer.
While it is difficult to be certain that a specific public announcement
conveys only one particular
type of information,
our sample design minimizes the probability
that new information
regarding firm asset values and risk
characteristics
is being released in close proximity
to the exchange offer
If debt, common and preferred stock are all Involved in the exchange offer. it is requtred
that the change in debt and preferred stock outstanding
be in the same directton
while the
change m common stock outstanding
be in the opposite direction. Exchanges whose sole effects
are to increase debt coupon rates and weaken Indenture covenants.
Increase debt maturity. or
Increase debt coupon rates while decreasing debt face value. arc among those events excluded
from this analysis.
Thus,
announcements
of new issues, redemptions
or repurchases
of securltles. mergers,
acquisitions,
spinoffs, major new Investments.
large new contracta
and large changes in net
mcome which exceed 25 percent of the value of the vzcurmea tendered tn the offer, as well as
announcements
of changes
m dividend
policy. late payment
of debt interest.
ImpendIng
bankruptcy,
major discoveries, and new patents which were made wlthin one week of the Initial
olTer announcement
dtsquahfled those events from the sample.
There are 19 and 6 events eliminated by criterja (3) and (4), respectively. Of the IY events
elimmated by criterion (4). almost all were the result of other announcements
made on the date
of the initial exchange offer announcement.
In addltlon, one should note that of the 163 events
In our sample. 29 mdehmtely postponed or cancelled their offers.
Exchanges
having a cash or asset component
in the offer less than 25 percent of the newly
issued securities value represented 23 events In the final sample.
announcement.
However, the relationship
between security price changes and
capital structure change can still be confounded
if capital structure change
announcements
consistently communicate
particular
insider information
concerning firm value to the market or have a significant impact on the market
assessment
of future changes
in the firms asset or capital structure.28
However, no systematic patterns of later (or earlier) capital or asset structure
changes were observed in the years that the offers occurred. A more extensive
analysis of the properties of the final exchange offer sample is available in
Masulis (1978).
3.6. Security
daily
mtes
ofreturn
Rates of return for NYSE and ASE listed common stocks for the three
months surrounding
the announcement
date were obtained from the Center
for Research in Security Prices Daily Rate of Return Tape covering the
period mid-1962 through mid-1976. The market rate of return is approximated by the rate of return on the Standard
and Poors 500 Stock Index,
which weights the stocks comprising
the index by their relative market
values.
Daily rates of return for preferred stock are calculated for the ten trading
days before and after the initial exchange offer announcement
data using the
closing prices listed in Standard and Poors N YSE D(lily Stock Record and
ASE Duily Stock Remrd.
Bid-ask averages are used when traded prices are
unavailable,
and cash dividends
are added to the rates of return on their
ex-dividend dates.
Bond rates of return are also calculated for ten trading days around the
initial exchange offer announcement.
Daily sule prices were obtained
from
the Wall Street Journul; if unavailable,
bid -ask averages were not used due to
limitations
in data availability
and reliability. Rates of return are adjusted for
daily interest accruals and coupon payment dates. Interest coupon rates and
payment
dates were obtained
from Standard
and Poors monthly
Bond
Guide.
While our overall sample is limited to firms with common stock listed on
the NYSE or ASE at the time of the exchange offer announcement,
the
outstanding
preferred stock or debt issues of the sample firms are not subject
to this criterion. Not surprisingly,
only a subset of the firms in the exchange
offer sample have preferred stock and/or
debt issues listed and actively
traded on one of the two major stock exchanges.
Tr~ter~on
(4) could in principle induce some selection bias ICI the results, in that exchange
offers may be associated wth the signalllng of insider information concerning firm value and
risk would be partially fIltered out by our sample criteria.
153
4. Methodology
4.1. Por[folio
formcdtion
in ewnt
time
The returns of the actively traded issues of preferred stock or debt listed
on the NYSE or ASE require further adjustment.
To eliminate any bias in
portfolio returns due to over-representation
of firms with multiple issues of a
given security class. security returns are weighted. The weights used arc the
reciprocals of the number of security issues per exchange offer represented in
a given portfolio, so that each exchange offer has equal weight in a giLen
portfolio of securities.
Separate portfolios of convertible
and non-convertible
debt and preferred
stock are formed in much of the analysis not only because differential price
effects are predicted
for various types of capital structure
changes (their
convertibility
into common stock implies that these securities should share in
the same effects observed
for the common
stock). but also because ,the
convertible
securities rate of return variance and systematic risk, on average,
are considerably
higher than those of the non-convertible
securities. This
latter characteristic
would tend to obscure effects of exchange offers on the
non-convertible
issues.
4.3. Meawremrr~t
of irlformution
&c.ts
on security
price
lEarlier
studvzs using this approach
Ibbotson (1975). and Ellert (1976).
include
Fama-Fisher
154
ing security
rates of return
r,, =
,LQ, +
&m
on security prices
is
&.
cfexchmgeofferson
,mxrity
prices
155
procedure:
The compmrison
period
returns
upprouch
156
difference
of means
test statistic
of the trrhles
5. Empirical results
In the results
to follow initial announcement
effects for increases and
decreases in leverage on common stock returns are presented. The sample of
common stocks is segmented by type of exchange offer into returns predicted
to exhibit tax and offsetting bankruptcy
effects. only redistribution
effects and
all three effects. The sample of preferred stocks is likewise segmented by type
of exchange
offer into returns
predicted
to exhibit
tax and offsetting
bankruptcy
and redistribution
effects, only redistribution
effects, and tax,
redistribution
and offsetting bankruptcy
effects. in analyzing debt. convertible
issues are separated from non-convertible
issues, and their respective returns
segmented into exchange offers predicted to cause tax and offsetting bankruptcy and redistribution
effects or no effect on debt prices. Lastly, debt
returns of issues having obviously incomplete protective covenants. which are
predicted
to exhibit larger redistribution
effects. are separated
from the
returns of other debt issues.
.See the discussion by Roll (1977), Gonedes (1973) and others.
This conclusion
should be even stronger in the case of daily returns as used III this study
since the signdicance
of the market model as Indicated by Its R IS much lower for daily data
than for monthly data.
R. IV Musu/i,s,
158
OH
scc,urit1 p~?wc
stock
Increasmg
N= 106
le\crage
Event
day
Portfolio
returns
-30
-20
-28
-27
-26
-25
-24
-23
7,
0.27
-0.40
-0.34
PO.04
O..%
0.05
-0.19
0.16
-0.30
0.20
0. I5
0.04
0.02
0.0x
~ 0.02
0.69
-0.18
-0.18
0.5 1
0.35
po.3x
-0.34
0.03
0.53
0.40
0.2)
0.16
0.62
0.15
0.50
-21
-20
~ 19
--. I 8
~ 17
~ I6
~ 15
- 14
~~ 13
~~ 12
PII
~ IO
-9
-8
-7
-6
-5
-4
-3
.~ 2
-I
rates
of return
for
inltlal
announcements
daily
(:A)
announcements
leverage.
Decreasing
iv=57
of offer5
leverage
Increasing
and
announcements
,: of stock
:,, of stock
returns >O
day
Portfolio
returns
38.0
36.0
25.0
31.0
41.0
39.0
26.0
33.0
32.0
34.0
35.0
33.0
38.0
39.0
38.0
35.0
35.0
32.0
43.0
42.0
42.0
31 .o
43.0
41.0
36.0
42.0
31.0
43.0
40.0
38.0
-30
-29
-28
-27
-26
-25
-24
-23
-22
-21
- 20
-19
-1x
-17
-16
-15
-14
-13
- 12
-II
~ 10
-9
-8
-7
-6
-5
-4
-3
7
-I
I.16
-0.48
-0.92
1.26
PO.49
0.28
I .22
0.16
0.60
0.87
0.0 I
0.15
PO.43
~ 0.0x
-0.01
- 0.20
0.24
0.74
0.12
-0.23
- 0.54
1.02
0. I 7
-0.13
1.43
- 0.43
-- 0.09
0.60
I .20
0.74
39.0
27.0
30.0
41.0
30.0
29.0
45.0
44.0
40.0
40.0
30.0
40.0
44.0
33.0
32.0
39.0
33.0
47.0
23.0
32.0
28.0
44.0
3Y.O
33.0
33.0
30.0
30.0
46.0
36.0
49.0
Event
dally
(7,)
returns
4.51
3.12
6Y.0
58.0
0
1
- 2.98
-2.39
11.0
25.0
2
3
4
5
6
0.00
-0.71
0.21
~ 0.09
-0.54
37.0
27.0
40.0
34.0
26.0
2
3
4
5
6
0.06
- 0.60
0.26
0.46
0.30
30.0
33.0
28.0
32.0
21.0
decreasing
>O
Increasing
N-106
leverage
Event
day
Portfolio daily
returns (f)
0
I
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
2x
29
30
0.15
-0.26
PO.06
0.19
- 0.08
0.46
- 0.33
-0.87
~ 0.05
0.00
0.56
0.41
0.09
0.05
0.53
0.20
-0.01
-0.52
0.10
0.48
- 0.23
0.35
0.35
0.17
announcements
y> of stock
returns>0
30.0
27.0
39.0
37.0
29.0
37.0
34.0
20.0
38.0
38.0
39.0
36.0
40.0
38.0
45.0
36.0
36.0
25.0
26.0
42.0
32.0
41.0
37.0
35.0
Cr~mp~risorr period
Portfolio mean daily return =0.07
Standard deviatron =0.35
Mean percent of stock dally
returns>O=35.0
Standard devration = 5.10
Decreasrng
N=57
Event
day
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
leverage
announcements
Portfolio dally
returns ( {,)
0.31
0.39
-0.14
~ 0.47
0.4 I
-0.68
- I .03
0.95
-0.21
-0.21
- 0.28
0.90
1.OO
0.88
0.74
-100
- I.11
0.89
0.08
0.57
- 0.96
0.92
- 0.45
0.60
:, of stock
returns > 0
35.0
39.0
37.0
29.0
33.0
28.0
26.0
37.0
35.0
30.0
26.0
39.0
34.0
37.0
30.0
21.0
28.0
40.0
23.0
33.0
30.0
33.0
32.0
30.0
period
Portfoho mean dally return = 0.12
Standard devration==O.hh
Mean percent of stock dally
returns>O=33.0
Standard deviation = 6.38
Comprrrison
given that more than 79 percent of these 106 common stocks have positive
returns for the two-day announcement
period,
we can conclude that these
results are not due to a few large outtiers. Testing for significant differences
between the portfolios announcement
period mean daily return and mean
percentage of daily returns strictly positive from their respective comparison
period means yields t statistics
of 14.6 and 7.8, respectively,
which are
statistically significant at the 5 percent level.
For the portfolio of leverage decreases, the two-day announcement
period
return is -5.4 percent, while over 84 percent of these 57 common
stocks
have negative returns for the announcement
period. Testing for significant
differences between the portfolios announcement
period mean daily return
and mean percentage of daily returns strictly positive from their respective
comparison
period means yield f statistics of 6.1 and 5.1. respectively, which
are also statistically significant. Thus, the stock price change appears to have
the same qualitative
relationship
to announced
leverage changes regardless of
the direction
of the change and in both cases represents highly significant
deviations
from the comparison
period means. The lack of any discernible
lagged effects after day 1 is consistent with the stock market prices efficiently
processing
new information
in exchange offer announcements.
Looking at
portfolio daily returns, there is little evidence of significant pre-announcement
information
leaks. However, in testing for insider information
leaks in certain
subsamples
of exchange offers, Masulis (1978) found evidence suggesting
insider information
leaks for 10 percent of the offers.
Increases and decreases in leverage are jointly
studied in most of the
following
analysis.
Returns
associated
with announcements
of negative
changes in firm leverage are normalized by multiplying
these securities rates
of return by a minus one before they are averaged with returns of securities
associated with announcements
of positive changes in leverage. Thus, all the
normalized
announcement
period returns
should exhibit the effects of
increasing leverage. The theoretical presumption
is that the effects of capital
structure change are unidirectional
once standardized
for the direction of the
firms leverage change. Not all theories are consistent with this presumption.
Specifically, some theories of optimal capital structure predict that the sign of
the combined tax and bankruptcy
cost effects is positive in all cases given
that the firms are maximizing
net present value. Consequently
the combid
effects of taxes and bankruptcy
costs are not undirectional
once standardized
the previous
evidence
is
for the direction
of leverage change. However
This is compared to a mean of 42 percent of these stocks havmg a two-day positive return
for the twenty-day
comparison
period surrounding
the announcement
period. The low percent
of stocks having a strictly positive two-day
return reflects the significant
probability
that a
realized return can equal zero due to either non-trading
of the security, or a price change that is
less than $118.
inconsistent
with this asymmetric
effect. Note that the entire time series is
not just the two-day
announcement
period. In a portfolio
normalized,
context this is analogous
to short selling securities of firms announcing
decreases in leverage.
5.1 .I.
Separation
of corporate
@cts
In an attempt to isolate the causes of the large exchange offer announcement effects, offers are separated by type of capital structure change. Based
on the earlier discussion
summarized
in table 1 (row l), common
stock
experiences positive corporate
tax and redistribution
effects and a negative
bankruptcy
cost effect in debt-for-common
exchange
offers. In debt-forpreferred offers, common stock experiences a positive corporate tax effect and
a negative bankruptcy
cost effect. In preferred-for-common
offers, common
stock experiences
a positive redistribution
effect. These predictions
suggest
that the average effect of debt-for-common
offer announcements
should be
equal to the sum of the average effects of debt-for-preferred
and preferredfor-common
offer announcements.
Furthermore,
a comparison
of the latter
two types of exchange offers yields separate estimates of the corporate
tax
and bankruptcy
cost effects and the redistribution
effect, assuming no other
effects such as those discussed at the end of section 2 are present.
In table 3, only the portfolio of common stock returns for 20 trading days
around the announcement
date are nresented:
the remainder
of the comparison period results can be found in Masulis (1978). Table 3 shows an
announcement
period return of 9.79 percent for debt-for-common
exchange
offer portfolio. The t statistic of the difference between announcement
and
comparison
period mean daily returns is 12.5. The announcement
period
return for preferred-for-common
exchange offer portfolio of 3.34 percent is
sti!l large. but considerably
below that for debt-for-common
offer portfolio.
The associated t statistic for the difference in announcement
and comparison
period mean daily returns is 4.5. Finally, in the case of debt-for-preferred
exchange offers, the portfolios announcement
period return is 4.63; these
returns
are again less than that found for the debt-for-common
offer
portfolio. The t statistic for the difference in announcement
and comparison
period mean daily returns is 5.8. In each case. the portfolio announcement
period mean daily return and mean percentage
of positive common
stock
daily returns
are significantly
different from their respective
comparison
period means (the r statistics for the difference between the announcement
period and comparison
period mean percentages of positive daily returns for
the three samples are 8.2. 4.5 and 5.8, respectively).
These results (especially the statistically
significant
announcement
effects
for columns two and three) indicate the presence of a redistribution
effect
Portfolio
returns
-0.22
-0.74
0.14
0.49
0.19
0.45
- 0.04
0.23
-0.57
0.85
6.01
3.78
- 0.06
-0.32
-0.47
- 0.18
1.02
-0.20
- 0.45
0.22
0.29
period
- 10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
2
7
8
9
10
Comparison
( li)
daily
exchange
39.0
24.0
33.0
25.0
36.0
32.0
34.0
27.0
25.0
73.0
61.0
39.0
27.0
41.0
39.0
42.0
38.0
25.0
32.0
37.0
43.0
Y, of stock
returns > 0
offers
0.19
-0.72
-0.75
0.60
0.02
0.52
0.50
- 0.90
- 0.04
- 0.66
2.13
1.21
0.57
- 0.59
0.63
- 0.94
-0.22
- 0.06
-0.22
-0.58
0.09
- 10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
(,)
daily
exchange
51.0
35.0
44.0
26.0
33.0
37.0
33.0
40.0
51.0
67.0
51.0
47.0
28.0
37.0
44.0
44.0
47.0
47.0
28.0
37.0
35.0
:/, of stock
returns > 0
offers
Comparison
period
Portfolio
returns
day
Event
Preferred-for-common
N=43
1.96
2.67
(%)
daily
exchange
37.0
37.0
49.0
40.0
42.0
35.0
26.0
40.0
38.0
69.0
56.0
53.0
35.0
42.0
35.0
35.0
44.0
35.0
47.0
38.0
24.0
The data
eliminated
showed
no large
% of stock
returns > 0
offers
Comparison perioll
Portfoho mean dally return =O.Ob
Standard deviation =0.55
Mean percent of stock
dally returns>O=
37.0
Standard dewatlon = 7.09
2
3
4
5
b
7
8
9
10
-9
-8
-7
-6
-5
-4
-3
- 0.65
0.20
0.26
-0.18
0.46
0.25
- 0.43
0.22
0.42
0.22
0.14
0.01
0.41
- 1.02
-0.23
0.26
1.00
-0.32
-0.50
- 10
Portfolio
returns
day
Event
Debt-for-preferred
N=43
Table
stock rates of return
To highlight
the announcement
effect i 10 trading days of the sample of _t60 days are presented.
positive or negative values nor any unusual patterns. The entlre table IS prebented in Masuhs (1978).
day
Event
Debt-for-common
N=85
Common
164
Table
Common
Offers to exchange debt
for outstandmg
N=34
_______
preferred stock
;, of stock
returns >O
Event
day
Portfoho daily
returns (I,)
I<, of stock
returns >O
Event
day
-10
-9
-8
-1
-6
-5
-4
-3
0. I.1
0.13
-0.28
0.38
-0.01
0.39
0.84
1.35
56.0
35.0
47.0
41.0
29.0
47.0
41.0
50.0
- 0.59
-0.19
- 1.10
-0.51
4.85
2.56
I.91
0.31
I .09
0.92
33.0
22.0
22.0
22.0
33.0
22.0
44.0
22.0
38.0
38.0
Portfoho dally
returns ( <,)
--0.14
0.40
24.0
41.0
- IO
-9
-8
-7
-6
-5
-4
-3
3
-1
0
1
1.50
0.63
65.0
50.0
0
1
-3.91
- IO.38
0.0
0.0
2
3
4
5
6
7
x
9
IO
-0.17
~ 0.43
0.76
-0.26
0.42
0.5x
-0.65
~ 0.25
0.20
38.0
29.0
53.0
38.0
44.0
32.0
26.0
41.0
41.0
2
3
4
5
6
7
x
Y
10
2.46
_ 2.55
I .64
-0.14
-0.61
1.00
-0.41
- I .Y7
- 1.20
33.0
22.0
44 0
22.0
22.0
44.0
11.0
1
r;
Cw~p~r~iso~~period
Portfoho mean daily return = 0.12
Slandard dcblatwn ~0.57
Mean percent of stoch
daily returns > 0 = 38.0
Standard dewatlon = 8.50
I I .o
33.0
CompUri,\on piotl
Portfoho mean dally return =O.
Standard deviation = 1.84
Mean percent of stock
daily relurns>O=29.0
Standard
-~-
decrease,
involved,
time.
5.12.
1X
~-
unnoum7eme~lt.s
two important
related announcements.
offer
Masulis (1978) explored
cancellations
and offer expirations
or terminations,
and found that for the 20
cancellation
announcements,
the announcement
period return (trading days
A number of addItIonal exchange offer related announcements are studted in Masulls (197X),
however, these announcement
effects were small m magnitude and generally not statistxally
slgnilicant with the exception of the announcement of the offer terms or alteration of terms.
165
While a significant
positive relationship
between common
stock price
changes and proposed
changes in firm leverage has been observed.
the
question remains as to whether capital structure change announcements
have
any effect on the prices of the actively traded preferred stock or debt. In an
attempt to answer this question, preferred stock daily returns are separated
by type of announced
capital structure
change to allow for !he different
predicted effects shown in table 1 (row 2).
To make the following results easier to interpret, plots are included of the
portfolios daily returns, standardized
by subtracting
p, the 19-day trading
comparison
period mean of these daily returns and dividing the remainder
by five times the standard deviation of these daily returns, CJ. Values greater
than five standard deviations from the mean are plotted at the five standard
deviation points. At the bottom of the plot is a scale measuring the number
of standard deviations from the comparison
period mean return that a given
portfolio daily return lies.
2Since
the data
on the cancellatwn
announcements
permd.
day
I ~~1s
Fig.
1. Preferred
for announcements
exchange
offers
effects on debt
by type
involved
of
m the
168
5.32.
Lkbt
corcwifflt~
If a redistribution
effect does cause part of the price change in debt issues,
separating
debt issues according
to whether or not they have incomplete
of the leverage
THERE
Fig. 5.
debt
1N THIS SAMPLE
Unprotected
ARE 26 StCURITIES
Convertible
rates
of return
OF 19 EVENTS
Issues with
Incomplete
for announcements
Debt
offers separated
Covenants
of exchange
Protective
by con\ertlblllty
5
w
Some important
implications
for merger studies can be derived from our
results. First of all, it does not necessarily follow that a change in common
stock value which occurs on the announcement
of a merger is a reflection of
a similar change in firm value. Changes in the values of the firms debt and
preferred stock (which can potentially
be offsetting) must bc analyzed before
this inference can be made.
Second, in a merger (as well as an acquisition
or divestiture) the associated
change in capital structure of the surviving firm can easily cause effects of the
same order of magnitude
as those induced by the exchange offers studied
here. Conscquently,
it does not necessarily follow that a change in firm value
or in security prices resulting from a merger announcement
is due to the
economic effects of a change in firm asset structure. The obserlcd effects may
be due in great part to the associated
capital structure
changes
(e.g..
corporate tax effects and redistribution
effects). which most empirical studies
of mergers have ignored. Moreover. by failing to note price changes in the
firms securities other than its common
stock. most of these studies have
tended to associate changes in the value of the firms common stock with
changes in the value of the firm itself. The previous results shed some light
on the empirical significance of this omission.
(1970). and
R.W
Mum/is.
Effects ofexchungr
175
6. Conclusions
Analyzing
a sample of relatively pure capital structure change announcements, evidence is found of statistically
significant
effects on the portfolio
returns of the firms common stock. preferred stock, and debt. This evidence
indicates both a corporate debt tax shield effect and a wealth redistribution
effect across security classes; no direct evidence of an expected cost of
bankruptcy
effect is found. A new methodology
is utilized to test the effects
of new information
on security prices and differs significantly
from previous
studies. The Comparison
Period Returns method is a straightforward
testing
procedure for assessing the significance of capital structure change announcements which is independent
of the particular asset pricing model specified.
A comparison
between the qualitative
predictions
of the hypotheses given
in table 1 and the average price adjustments
observed for major security
classes at-the time of capital structure change announcements
support the
following findings:
(1) Capital structure changes predicted to cause either a corporate debt tax
shield effect or a wealth redistribution
effect are associated with security
price changes consistent with these predictions.
(2) Security price changes are relatively larger in cases where the corporate
tax and redistribution
effects are predicted to reinforce each other, and
smaller in cases where the corporate
tax and redistribution
effects are
predicted to run counter to each other.
(3) Offsetting price changes in individual
firms major
observed, as predicted by the wealth redistribution
various capital structure changes studied.
(4) As predicted
by the wealth redistribution
hypothesis,
relatively
large
price adjustments
are observed for debt issues which do not restrict the
issuance of new debt of equal or senior standing.
(5) On average,
stockholders
are adversely
affected by a decrease
in
leverage, which suggests that firms do not always follow a policy of
maximizing
stockholder
wealth. These decisions
may or may not be
consistent with maximizing the firms net present value.
(6) No evidence of a bankruptcy
cost effect is found for the firms decreasing
leverage in case where wealth redistribution
effects are not present. This
surprising
result appears to be inconsistent
with the predictions
of the
corporate tax-bankruptcy
cost models of optimal leverage.
In summary, the qualitative
redistribution
effects resulting
predictions
of the corporate
tax and wealth
from a capital structure change are observed,
as detailed
in table
1, for all three
major
classes of firm securities.
No
evidence of an expected cost of bankruptcy
effect is observed. Nevertheless, it
is always possible that a portion of the observed price adjustment
is due to
other effects not considered here such as the signalling hypothesis. This is a
question left for future research.
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