Convertible calls and corporate taxes under asymmetric information |
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Institution: | 1. The University of Manitoba, Faculty of Management, Department of Accounting and Finance, Winnipeg, Man., Canada R3T 5V4;2. New York University, Stern School of Business, 44 West Fourth Street, New York, NY 10012, USA |
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Abstract: | This paper develops a signalling model of call of convertible securities (bonds or preferred stock) in the presence of corporate taxes and asymmetric information about future earnings. In equilibrium, managers with relatively unfavorable information call to force convertible holders to convert to common stock (in spite of the loss of corporate tax benefits if the convertibles are bonds), while those with relatively favorable information do not call. The model predicts that the announcement period common stock returns are more negative at the call of convertible bond than at the call of convertible preferred stock. Furthermore, we predict that when the importance of the tax deductibility of interest differs among firms, so does the stock price reaction to the announcement of convertible debt call. Specifically, the loss of equity value at the announcement decreases with the amount of non-debt tax shield that the calling firm owns, decreases with the book value of convertible debt called, and increases with corporate taxes. |
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