Capital Structure Change and Decreases in Stockholders' Wealth: A Cross-Sectional Study of Convertible Security Calls

Abstract

This paper is a cross-sectional analysis of the relationship between common stock price reactions to announcements of convertible security calls and variables that represent possible determinants of changes in common stockholders' wealth.The variables are measures of the following effects of convertible security calls: (1) the change in interest expense tax shields, (2) the potential redistribution of wealth from common stockholders to preferred stockholders and debtholders,(3) the decrease in the value of conversion privileges held by convertible securityholders, (4) the relative increase in shares outstanding and (5) the change in earnings per share.A significant relationship is found only between the measure of the reduction in interest expense tax shields and the stock price response to call announcements.The apparent corporate tax effect is consistent with some combination of effects due to (1) a reduction in interest expense tax shields and (2) unfavorable information about the calling firm's value or earnings prospects that is conveyed by a call of convertible securities.The evidence is consistent with theories of capital structure that imply optimal financial leverage depends on earnings prospects and with theories that imply reductions in leverage convey unfavorable information about firm value.

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