When are Preferred Shares Preferred? Theory and Empirical Evidence

Vicente Pons-Sanz, Shlomit Zuta, Aharon Ofer, S. Ravid and Itzhak Venezia

Yale School of Management Working Papers from Yale School of Management

Abstract: This paper demonstrates that preferred stock may arise as an optimal security in a tax-induced equilibrium. This result is driven by graduated tax schedules and by uncertainty. In a more general sense, our results can be interpreted as a template for including any security with a different tax treatment in a firm's capital structure. The first part of the paper demonstrates that the Miller (1977) equilibrium framework can accommodate more than two securities if different investor classes are taxed differently on each security and the tax schedule for each investor group is upward sloping. We then simplify the tax schedule, but introduce uncertainty, which implies the possibility of bankruptcy and the possible loss of tax shelters. The interaction of tax rates and seniorit

Date: 2004-04-01, Revised 2004-06-01
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