Journal of Accounting Research

(Autumn 1999)

Debt-Equity Hybrid Securities

Ellen Engel*, Merle Erickson* and Edward Maydew*

1. Introduction

This paper exploits the features trust preferred stock to examine several tax and
financial reporting issues. Trust preferred stock, first issued in 1993, was engineered to be
treated as preferred stock for financial statement purposes and as debt for tax purposes
(i.e., payments on trust preferred stock are deductible by the issuer).1 Our analyses are
intended to shed new light on three issues: i) the extent to which firms will incur costs to
manage the balance sheet classification of a security; ii) the magnitude of net tax benefits,
if any, associated with leveraging increasing capital structure decisions, and iii) the extent
to which investor-level taxation imposes implicit taxes on securities.

*
Graduate School of Business, University of Chicago. We thank Goldman Sachs for providing
data. We received helpful comments from workshop participants at the 1997 Illinois Tax
Symposium, the 1997 Stanford Summer Camp, the National Tax Association 90th Annual
Conference on Taxation, Brigham Young, Chicago, Columbia, Cornell, Harvard, Iowa,
Michigan State, Penn State, Texas and Wisconsin. We also appreciate comments from Brad
Barber, Tom Dyckman, Jennifer Francis, Greg Geisler, David Guenther, John Hand, David
Harris, Doug Hanna, Bob Holthausen, Amy Hutton, Michael Knoll, Lil Mills, Kaye
Newberry, Dana Northcut, Kathy Petroni, John Phillips, Doug Shackelford, Terry Shevlin,
Toshi Shibano, Abbie Smith, Bob Trezevant, Linda Vincent, Terry Warfield, and an
anonymous referee. We appreciate helpful discussions and background materials from Tom
Driscoll (Ernst and Young LLP), Larry Gorski (Illinois Insurance Bureau), Jim McConnell
(Arthur Andersen LLP), Richard Stuart (Financial Accounting Standards Board) and Robert
Willens (Lehman Brothers). Ira Weiss provided excellent research assistance. We appreciate
financial support from the University of Chicago Graduate School of Business. Ed Maydew
also thanks the Price Waterhouse Foundation for financial support.
1
The word ‘trust’ comes from the fact that these securities are usually issued through trusts.
Our database includes trust preferred issues with the following names: MIPS (Monthly
Income Preferred Securities) and QUIPS (Quarterly Income Preferred Securities) developed by
Goldman Sachs, TOPRS (Trust Originated Preferred Securities) developed by Merrill Lynch,
and TRUPS (Trust Preferred Stock) developed by Salomon Brothers. Section 2 discusses the
how these securities work and how their structures have evolved.
 Debt-Equity Hybrid Securities

Our sample contains 158 trust preferred stock issuances between October 1993
and December 1996. To examine whether firms pay for the ‘balance sheet label’ attached
to a financing instrument, we focus on 44 firms that use the proceeds of trust preferred
stock issuances to retire debt. Since trust preferred stock and debt are treated similarly for
tax purposes, this set of firms appears to be motivated, in part, by the desire to reclassify
obligations out of the liability section of the balance sheet. Prior research has examined
transactions structured to keep liabilities off the balance sheet; for example Bowman
[1980], Imhoff [1988], and Ely [1995], focus on the financial reporting impact of leasing
transactions, and Shevlin [1987] examines off-balance sheet financing in the context of
R&D limited partnerships. Other research examines more generally the trade-offs of tax,
financial reporting, and regulatory objectives in capital structure decisions.2 In contrast,
we examine a capital structure decision which determines the label of the security within
the balance sheet. In the trust preferred-for-debt exchanges, tax and, where applicable,
regulatory goals are not compromised – the trade-off is measured instead in direct and
indirect costs of an alternative capital structure choice. While prior research suggests that
firms care about balance sheet treatment, we extend the literature by quantifying the costs
firms incur to manage their balance sheets. Our estimates show that sample firms paid
between $10 and $43 million to reduce debt-to-assets ratios by 12.8%, on average,
suggesting a willingness to incur substantial costs to achieve reclassification of a tax-
equivalent capital source on the balance sheet. These estimates are to our knowledge the
first quantification of what firms are willing to pay to manage their balance sheets.
Our setting also allows us to estimate the magnitude of the tax benefits from
leverage. Existing theoretical analyses suggest upper and lower bounds on the value of the
tax deductibility of interest costs. Depending on what is assumed, theory indicates the tax
gain from leverage could be as little as zero (Modigliani and Miller, 1958; Miller, 1977) or
as large as τD, where τ is the corporate tax rate and D is the amount of debt issued
[Modigliani and Miller, 1963]. Exactly where in this range the tax benefits of leverage fall
is an empirical issue.
Existing empirical studies,3 however, have been unable to separate the tax effects
from other potential confounding factors, such as risk, signaling and agency costs. We
overcome this problem by examining a capital structure transaction involving two
securities that are nearly identical except for their tax treatment. This set of tests focuses
on 28 firms that issue tax-deductible trust preferred stock to retire non-deductible
traditional preferred stock. The resulting tax savings are reduced by direct transactions
costs and by any differences in the pretax required returns on trust and traditional
preferred stock. After taking these factors into account, our direct estimates of tax benefits
indicate that the present value of the net tax savings averages 28% of issue size across our
sample (approximately 80%, on average, of the estimated upper bound), which suggests
that the tax benefits of leverage can be quite large.

2
For example, Scholes, Wilson, and Wolfson [1990], Collins, Shackelford, and Whalen [1995],
Beatty, Chamberlain, and Magliolo [1995], and Mikhail [1997].
3
See, for example, Kaplan [1989], Schipper and Smith [1991], and Graham [1996].

2
 Debt-Equity Hybrid Securities

In our third set of analyses, we provide evidence on the extent to which investor-
level taxation affects the equilibrium pricing of securities by comparing yields on trust
preferred stock to yields on traditional preferred stock. Because trust preferred stock is
tax-advantaged relative to traditional preferred stock at the issuer-level, and tax
disadvantaged at the investor-level, investors will demand a higher pretax return on trust
preferred stock - representing an implicit tax cost to issuers of such securities.4 While it is
difficult to determine the extent to which investor-level taxation affects pretax returns
when different taxpayers are taxed differently on the same asset (Scholes and Wolfson,
[1992]; Dyvbig and Ross [1986]), theory does allow us to calculate the theoretical upper
and lower bounds of the implicit tax cost of issuing trust preferred stock relative to
traditional preferred stock. Exactly where the implicit tax costs lie within this range in a
setting with differentially taxed securities and differentially taxed investors is an empirical
question.
In general, empirical researchers testing for implicit taxes have found it difficult to
control for risk differences between differentially taxed securities. Empirical papers that
have examined implicit taxes include Shackelford [1991; in the ESOP loan market],
Berger [1993; the R&D tax credit], and Guenther [1994; in Treasury bills] and Erickson
and Maydew [1998; in high dividend yield equity securities]. Further, we avoid concerns
of risk differences across securities because the credit ratings are identical for the two
securities in nearly every case. The ability to hold risk constant while varying the tax
treatment is what allows us to isolate the implicit tax effects.
We find that the implicit tax cost, expressed as a tax rate, averages 2.33% (5.10%
median). This estimate is much closer to our computed lower bound of zero than the upper
bound of 27% and suggests a discernable but small effect of investor-level taxation on
pretax returns similar to that found in studies of the tax-exempt municipal bond market
(Poterba [1986] and Mankiw and Poterba [1996]).
The paper proceeds as follows. In the next section we describe the structure and
taxation of trust preferred stock, as well as its financial reporting and regulatory effects.
In Section 3 we present descriptive data on our sample of trust preferred issues and
issuers. In Section 4 we estimate the magnitude of net tax effects associated with trust
preferred stock issues and examine the extent to which trust preferred issuers appear
willing to pay to manage their balance sheets. We quantify the implicit tax cost related to
trust preferred stock in Section 5. Section 6 concludes.

4
Typically, implicit taxes are viewed from the investor’s perspective. Since we are examining
the issuer’s decisions, we adopt the term ‘implicit tax cost’ to refer to the extra pretax return
that the issuer must offer on securities that are tax disfavored to investors.

3
 Debt-Equity Hybrid Securities

2. The Structure of Trust Preferred Stock and Its Tax, Financial Statement and
Regulatory Treatment

2.1 THE STRUCTURE OF TRUST PREFERRED STOCK

The first trust preferred issue by a U.S. firm was a $350 million issue by Texaco
on October 27, 1993. Figure 1 illustrates the structure of the Texaco trust preferred
offering. Since most trust preferred offerings follow the same basic structure, we use this
offering to describe the structure of trust preferred stock.
Texaco created a wholly-owned 'shell' subsidiary, Texaco Capital LLC,
capitalized with a minimal amount of cash (e.g., $100) in exchange for all of the common
(voting) equity of the subsidiary. In related transactions, Texaco Capital then issued trust
preferred stock to investors for $350 million in cash and Texaco issued $350 million of
subordinated debentures to Texaco Capital in exchange for the $350 million proceeds of
the trust preferred issue. The terms and yield of the Texaco debentures are identical to
those of the trust preferred stock, so the debentures provide the cash to make the dividend
payments to trust preferred holders. For example, Texaco Capital’s trust preferred stock
pays dividends at 6.875%, identical to the yield on the subordinated Texaco debt held by
Texaco Capital. Texaco Capital is thus structured as a conduit between Texaco and the
trust preferred investors, with interest payments from Texaco on the debentures equaling
the dividends paid to the trust preferred investors. Texaco Capital has two classes of
stock: trust preferred stock owned by outside investors, and common stock owned by
Texaco.
Contractually, trust preferreds are similar to traditional preferred stock. Texaco’s
trust preferreds have maturities of 50 years with a 50 year renewal option, so their market
value derives almost entirely from their dividend payments. Most trust preferreds have
maturities between 20 and 50 years, with similar renewal options. Also like traditional
preferred stock, Texaco’s trust preferreds are subordinated to all other debt with weak
covenants. For example, Texaco’s trust preferred investors cannot prevent the issuance of
additional debt senior to the trust preferreds. Texaco can also defer payment of trust
preferred dividends for up to five years at a time, although as with traditional preferred
stock, dividends on common stock are prohibited if the issuer is deferring trust preferred
dividends. In the unlikely event of dividend deferral exceeding five years, trust preferred
investors could appoint an outside trustee to Texaco Capital, which could then sue Texaco
for defaulting on its debt obligation to Texaco Capital.5

5
See Hariton [1994] for a further detailed review of the structure and taxation of trust preferred
securities.

4
 Debt-Equity Hybrid Securities

2.2 TAX TREATMENT OF TRUST PREFERRED STOCK

As a limited liability corporation (LLC), Texaco Capital is treated under U.S. tax
law as a partnership,6 so it is not consolidated with Texaco for tax purposes (unlike for
financial reporting purposes). Since Texaco Capital is a partnership and not a corporate
subsidiary of Texaco for tax purposes, Texaco is able to deduct the interest payments it
makes to Texaco Capital.
Because Texaco Capital is taxed like a partnership, there is no taxation at the
entity level. Instead the trust preferred holders are treated as “partners” in Texaco Capital
for tax purposes and are taxed on their share of Texaco Capital’s interest income (I)
received on the Texaco debentures. Technically, the cash payments (C) the trust preferred
holders receive are treated as distributions from the partnership and are not, in and of
themselves, taxable. Since the trust preferred stock and subordinated debt have identical
interest rates and face values, I=C. So taken as a whole, the taxation of trust preferreds is
the same as debt: the annual payments to investors are tax-deductible to the issuer and
fully taxable to investors.
The tax treatment of traditional preferred stock differs from that of trust preferred
for both issuers and investors. While issuers receive no tax-deductions for dividends paid
on traditional preferred stock, the securities are tax-advantaged to corporate investors
because the “dividends received deduction” exempts 70% of the dividend income from
taxation.7 Holders of trust preferred stock are not eligible for the dividends received
deduction since the trust preferred securities are allowed debt treatment. Because trust
preferred stock is not tax-advantaged to investors relative to traditional preferred stock it is
likely that issuers have to offer a higher pretax yield on trust preferred stock (i.e., an
implicit tax cost). Whether issuers benefit from replacing traditional preferred stock with
trust preferred stock depends on the size of the implicit tax cost and firm-specific marginal
tax rates. The differential taxation of trust preferred and traditional preferred stocks
should also induce a clientele effect whereby trust preferreds are held mainly by
individuals or institutional investors, while conventional preferred stock is held mainly by
corporate investors.8

6
Internal Revenue Code Section 701. Early trust preferred conduits had to avoid the
'association' test of Treas. Reg. 301.7701, but now only have to satisfy the more relaxed
'check-the-box' regulations that have amended those sections.
7
The dividends received deduction (Internal Revenue Code Section 243) is designed to
mitigate potential ‘triple taxation’ when corporations receive dividends from other
corporations. The dividends received deduction can be higher when the corporation receiving
the dividend has greater than 20% ownership in the paying corporation.
8
Sheppard [1996] argues that holders of trust preferred stock are individuals and institutions in
her reference to trust preferred stocks as a retail product. Erickson and Maydew [1998]
provide evidence that corporations are significant holders of traditional preferred stock.

5
 Debt-Equity Hybrid Securities

Early trust preferred-issuing subsidiaries were structured as limited liability

companies (LLCs) domiciled in a tax haven. However, the tax haven was used for non-tax
purposes, and not to facilitate income shifting across jurisdictions.9 Specifically, early
trust preferred issues faced the risk that U.S.-based LLCs or partnerships would not be
exempt from registration under the Investment Company Act of 1940 that pertains to
mutual funds. Later, the SEC granted an exemption, clearing the way for use of U.S.
domiciled limited partnerships, trusts, and LLCs, particularly Delaware business trusts.
Issuing through a trust has record-keeping advantages for investors, who receive annual
1099 statements rather than the more complex K-1 statements issued to holders of LLCs
and partnerships. An issuer’s status as a business trust, partnership or LLC has no impact
on the taxable income of the investor or issuer nor on the issuer’s financial statements in
this setting.
In December 1995, the Clinton Administration proposed certain tax measures,
including provisions unfavorable for trust preferreds, as part of the annual budget package
submitted to Congress. The proposals would have denied interest deductions on securities
with maturities longer than 20 years that are not presented as debt on the balance sheet.
The proposals were not included in any of the 1996 tax legislation nor in the Taxpayer
Relief Act of 1997. If enacted, these proposals would not have affected outstanding issues
of trust preferred stock. In anticipation of legislation, investment banks had developed
versions of trust preferred stock that would avoid the proposed constraints, although at
some cost.10 Recently, the IRS resolved the issue by ruling that annual payments relating
to trust preferred securities are tax deductible by issuers.11

2.3 FINANCIAL REPORTING TREATMENT OF TRUST PREFERRED STOCK

The treatment of trust preferred securities for financial reporting purposes differs
from that of both debt and traditional preferred stock. Continuing with the Texaco
example, for financial accounting purposes Texaco Capital is a wholly-owned consolidated
subsidiary of Texaco. Therefore, the intercompany loan between Texaco and Texaco
Capital LLC is eliminated in the consolidation.
The trust preferred obligations are typically presented on the balance sheet as a
separate line item between liabilities and shareholder’s equity, often described as
“obligations under mandatorily redeemable preferred securities of affiliate” or “minority
interest in subsidiary companies.” Trust preferred stock is generally not classified as a

9
Examples of papers investigating income shifting across countries include Harris [1993] and
Klassen, Lang, and Wolfson [1993].
10
The Treasury also issued two warnings in 1994 that they would scrutinize future trust
preferred offerings (Rev. Notice 94-47, Rev. Rul. 94-28). It is interesting to note that
Treasury has always had enough authority under I.R.C. Sec. 385 to reclassify trust preferred
stock as equity, which would effectively eliminate its appeal. No act of Congress is necessary
(see Sheppard, 1994). Perhaps because Treasury chose a weak form of intervention, the pace
of trust preferred issues continued unabated.
11
IRS Letter Ruling # 9910046 dated 11/16/98.

6
 Debt-Equity Hybrid Securities

liability, and is instead treated as a form of quasi-equity.12 Ratings agencies treat trust
preferreds as equity-like because of their long maturities, deep subordination, and dividend
deferral options. On the income statement, trust preferred ‘dividends’ are included within
operating expense.

2.4 REGULATORY TREATMENT OF TRUST PREFERRED STOCK

While our primary focus is not on regulatory accounting issues, we acknowledge

their effects since many trust preferred issuers are commercial banks, insurance
companies, and utilities. We briefly discuss each of these three industries separately
because the regulatory issues are industry-specific.
Commercial banks face capital requirements as a percentage of total assets and
‘risk-weighted’ assets, adjusted for varying levels of risk of different assets (e.g., cash is
less risky than mortgage receivables). Most banks operate well-above minimum
requirements and have several incentives to do so. First, banks with high capital ratios can
be designated ‘well-capitalized banks’ by the Federal Reserve. Such banks enjoy more
operating freedom (e.g., the ability to expand into non-banking activities). Second, banks
reportedly stockpile capital in healthy times to protect against economic downturns.13
Initially, it was unclear whether the Federal Reserve would approve trust
preferreds as regulatory capital. Investment banks worked to develop versions of trust
preferreds that would be both tax-deductible and includible in regulatory capital. In mid-
1996, Salomon Brothers requested a Federal Reserve ruling on the inclusion of its
specially developed trust preferred known as TRUPS in regulatory capital. On October
21, 1996, the Federal Reserve ruled that trust preferreds may be included in regulatory
equity capital. As we document in Section 3, this treatment appears to have been a de
facto prerequisite for commercial banks to issue trust preferred stock.
The financial health of insurance company operating subsidiaries is also monitored
by regulators who generally look to 12 financial ratios, which include various profitability,

12
During the period covered by our study, the balance sheet treatment of trust preferred stock
was guided by Section 211 of the SECs Codification of Financial Reporting Policies (formerly
Accounting Series Release No. 268) which addresses appropriate balance sheet presentation
of preferred stock subject to mandatory redemption requirements. Specifically, because trust
preferred stock is redeemable at a fixed and determinable price and date, it cannot be
presented in the equity section of the balance sheet. Financial Reporting Policies (FRP)
Section 211 also emphasizes that redeemable preferred stock should not be regarded as a
liability and that the classification should not require any change in the calculation of debt-
based ratios. While the income statement treatment of annual payments on trust preferred
stock is not specifically addressed by FASB or SEC pronouncement, the treatment is
consistent with the reporting of annual payments as a deductible expense for tax purposes.
13
The Washington Post reports that “banks don’t need the capital right now, but since real
estate prices plummeted in the early 1990s banks have loaded up on equity capital and many
exceed the Fed’s requirement that capital equal 6% of assets to be considered well-
capitalized.” (Feb. 5, 1997, p. D10).

7
 Debt-Equity Hybrid Securities

liquidity and reserve adequacy measures.14 However, regulatory issues are not likely to be
important motivations for our sample firms with insurance operations because trust
preferred stock, like other external financing instruments, is typically issued at the holding
or parent company level rather than at the subsidiary or individual insurer level.
Regulatory reporting applies only at the individual insurer level rather than the holding
company level and thus, the existence or classification of trust preferred stock by the
holding company does not affect regulatory ratios.
Utilities are regulated at both the state and federal levels, not so much to assure
financial stability as to determine allowable rates. Since utilities are generally assured a
‘fair’ return on capital, reductions in financing costs will normally be passed on to
customers in the form of lower rates.15 However, due to recent deregulatory activity in the
industry, utilities are becoming increasingly subject to the rewards and punishments of the
marketplace and thus, have incentives to behave like unregulated firms and attempt to
lower their cost of capital. Thus, regulatory considerations are not likely to be important
motivations for utilities to issue trust preferred stock during our period of study.

3. Sample and Descriptive Statistics

We obtained our sample of trust preferred issues from Goldman Sachs,

supplemented by a search of Lexis/Nexis using terms such as ‘trust preferred’ and various
acronyms used by investment banks (e.g., ‘TRUPS’). This process resulted in a sample of
158 trust preferred stock issues totaling $36 billion during the period October, 1993 to
December, 1996.
Table 1 presents descriptive information about the sample. Panel A details the
number and dollar value of trust preferred issues by industry on a quarterly basis. Clearly,
the volume of trust preferred issues increased over the sample period with a substantial
number of issues in late 1996. Over 70% (by value) of fourth quarter 1996 issuances were
by financial service firms, accounting for two-thirds of total trust preferred issuances in
the industry over the sample period. This surge in trust preferred activity by financial
service firms, particularly commercial banks, corresponds with the October, 1996 Federal
Reserve Board ruling, suggesting that regulatory factors likely play a key role in
encouraging the issuance of trust preferred by commercial banks.16

14
The National Association of Insurance Commissioners (NAIC) sets guidelines for these ratios,
which are reported as part of the Insurance Regulators Information System (IRIS), but
ultimate regulatory decision making rests with the state regulators. See Petroni [1992],
Petroni and Shackelford [1995], and Mikhail [1997] for general discussions on insurance
regulation and the effects of regulatory scrutiny.
15
For a general description of the cost of capital in a regulated utility, see Tole and McCord
[1986].
16
The category of financial service firms includes commercial and investment banks and other
investment companies (firms with 2-digit SIC codes 60 through 62 and 67). Regulatory
capital requirements are of greatest concern to commercial banks. Further analysis of the
composition of financial service firm issuers by quarter reveals that issuers before the Federal

8
 Debt-Equity Hybrid Securities

Since their introduction in late-1993, the number of trust preferred issues has
gradually exceeded that of traditional preferred issues. Frischmann and Warfield (1998)
report that by 1996 over half of all new preferred issues were of trust preferred stock.
Panel A shows that most trust preferred issuers - utilities and financial services firms -
tend to be heavy users of traditional preferred stock. This regularity in our data is
consistent with statements in the financial press, indicating that trust preferreds are viewed
as a tax-deductible form of preferred stock.
Press releases that accompany trust preferred offerings typically discuss the
intended use of the issue proceeds. We collect and analyze this information because the
use of the proceeds has both tax and financial reporting implications. As documented in
Panel B of Table 1, 63 of the issues were used to retire debt, 46 to retire preferred stock,
and 107 for general corporate or other purposes. Because firms often list multiple uses
(e.g., to repay short term debt and for general corporate purposes) the total number of
intended uses exceeds the number of sample issues reported in Panel A.
Table 2 presents descriptive financial information for trust preferred issuers by
industry along with comparable financial information for firms with outstanding traditional
preferred stock and all Compustat firms in the issuers’ industry. Several observations can
be made with respect to these data. First, trust preferred issuers tend to be quite large with
average market capitalizations (across all industries) of approximately $6 billion. The
firms are, on average, also large relative to other firms in their industries. Second, trust
preferred issuers are likely to have also issued traditional preferred stock; the percentage of
sample firms with traditional preferred stock ranges from 58% (‘other’ industries) to 100%
(utilities). This compares to a range of 16% (‘other’ industries) to 56% (utilities) of all
firms in the same industry as trust preferred issuers. Third, trust preferred issuers tend to
be profitable with mean and median return on assets and equity in all industry groups
generally equaling or exceeding that of other industry members. Similar inferences are
drawn from descriptive data (not tabulated) classified by intended use of proceeds.

4. Estimated Tax Benefits and Costs of Balance Sheet Management Associated

with Trust Preferred Stock

In this section we estimate the tax benefits and costs of balance sheet management
associated with replacing traditional preferred stock and debt, respectively, with trust
preferred stock. We identify firms that obtain primarily tax benefits as those announcing
intentions to either exchange trust preferred stock for traditional preferred stock, or to use
the trust preferred proceeds solely to retire traditional preferred stock. Our direct
estimation of tax benefits arising in trust preferred for preferred stock recapitalizations is
similar in spirit to that of Kaplan (1989) and Schipper and Smith (1991), who estimate the
tax benefits associated with leveraged buyouts.

Reserve Board’s ruling include investment banks and other investment companies. The first
issue of trust preferred stock by a commercial bank was made after the Federal Reserve
Board’s ruling in October, 1996.

9
 Debt-Equity Hybrid Securities

We estimate the amount firms are willing to pay for the balance sheet label
associated with trust preferred stock as the direct costs paid by issuing firms whose stated
intent is to use trust preferred proceeds to retire debt.17 These direct-cost estimates are a
lower-bound of the costs; they are amounts firms actually paid, rather than the maximum
amounts they would have been willing to pay. We estimate an upper-bound by computing
the tax savings foregone by using trust preferreds to retire debt rather than to retire
traditional preferred stock. Our use of directly observable tax costs to gauge what firms
pay for balance sheet management is similar to Maydew, Schipper and Vincent (1999),
who estimate how much tax divesting firms pay to increase reported income.
We do not examine why firms choose to issue trust preferred stock instead of
traditional preferred stock or choose to issue preferred stock instead of common stock or
debt. Frischmann and Warfield (1999) examine the choice among preferred stock
alternatives, finding that tax factors appear to dominante the issue decision, with trust
preferred issuers having higher tax rates than issuers of traditional preferred stock on
average. Studies examining the decision to issue preferred stock (e.g., Collins and
Shackelford (1992), and Callahan, Shaw and Terando (1997)) highlight primarily tax and
regulatory factors.

4.1 ESTIMATES OF TAX SAVINGS FROM ISSUING TRUST PREFERRED STOCK

TO RETIRE TRADITIONAL PREFERRED STOCK

In this section we use our sample of trust preferred stock issuances to estimate the
net tax benefits from leverage. This analysis uses the set of trust preferred issuers that
announce their intention to use the proceeds to retire existing preferred stock. We estimate
the present value of the tax savings resulting from the shift in capital structure, adjusted
for differences in the pre-tax cost of the securities. Of the 158 trust preferred issues in
our sample, 28 were made solely to redeem outstanding preferred stock. All analyses in
this section relate to these 28 transactions.
We estimate the net tax savings (i.e., the present value of the tax savings, net of
costs of issuing the securities) for firms replacing non-deductible preferred stock with tax-
deductible trust preferred as follows:18

P [ R pref − Rtrust( 1 − t) ]
Present Value of Net Tax Savings = − uP (1)
Rdebt

where: P is the principal amount of the trust preferred issue,

Rtrust is the pre-tax yield of the trust preferred stock issued,

17
In these analyses, we do not include firms who intend to retire both debt and traditional
preferred stock with the trust preferred issue proceeds.
18
We capitalize these savings in perpetuity because of the long maturities and renewal options
associated with trust preferred stock. We discount using the rate payable on the comparably
risky bonds and present sensitivity analyses using an alternative rate.

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 Debt-Equity Hybrid Securities

Rpref is the pre-tax yield of the traditional preferred stock retired19,

Rdebt is the pre-tax yield of on debt of comparable risk and maturity as the trust
preferred stock,
t is the marginal tax rate, assumed to be 35%
u is the direct underwriting cost as a percentage of the trust preferred issue

We separate (1) into estimates of the present value of the total tax savings (shown
in (2)) and estimates of the issuance cost (shown in (3)). We use the following equation to
estimate the present value of total tax savings:

P( Rdebtt ) P( Rdebt − R pref )

Present Value of Total Tax Savings = − (2)
Rdebt R
14243 144 4debt
2444 3
interest implicit tax cost
tax shield

where all variables are as defined in (1).

The first term of (2) reflects the value of the tax shield from the deductible
dividend payments on trust preferred. We use Rdebt rather than Rtrust in the numerator of (2)
to estimate the maximum tax savings achievable by replacing non-deductible preferred
stock with tax-deductible securities. We do so because firms interested in the tax shields
associated with interest deductions could have issued debt instead of trust preferred stock.
This term, which simplifies to Pt, is equivalent to the well-known τD discussed in the
finance literature.
The second term of (2) reflects the implicit tax cost associated with replacing tax-
favored returns (to investors) on preferred stock with tax disfavored returns on trust
preferred (taxed like interest income on debt securities). Traditional preferred stock is tax-
advantaged to corporate investors and, should therefore pay lower returns than non-tax
advantaged securities of similar risk. Replacing traditional preferred stock with securities
that are not tax-advantaged to investors will force the issuer to pay a higher pretax return
(i.e., an implicit tax cost); in other words, the issuers lose the implicit taxes they used to
collect from investors.
The second component of (1) reflects the total costs of issuing trust
preferreds as shown in (3):

19
Theoretically, the pre-tax effective yield of the traditional preferred stock retired should be
used in this estimation. We use the stated rate since it is available for all sample firms, while
the effective rates could be determined for only 23 of the 28 sample firms. We conduct
sensitivity analyses for the subset of firms for which effective rates are available to determine
the potential effect on our estimates and results are qualitatively similar.

11
 Debt-Equity Hybrid Securities

P( Rtrust − Rdebt )( 1 − t )
Total Costs of Issuance = + uP
{ (3)
R
14444debt 244443 underwriting spread
additional premium paid
on trust preferreds

where all variables are as defined in (1). The underwriting spread is the
investment bank's fee estimated as the difference between the face value and the net
proceeds of the issue, since with few exceptions trust preferreds are issued at par.
The additional premium paid on trust preferreds reflects the after-tax cost of trust
preferreds less the after-tax cost of comparably risky debt, capitalized in perpetuity.20 We
estimate the yield of comparably risky subordinated debt as being 0.3% less than the
actual yield on the trust preferred stock based on the estimates of underwriters, who
observe that investors are reluctant to purchase these exotic-sounding securities (e.g.,
MIPS, TOPRS) unless they receive a slightly higher yield. 21 If investors do not demand
such a premium, then our estimates of the costs of issuing trust preferred would be
overstated, while if investors demand a higher premium on trust preferred than 0.3%, our
estimates of issue costs are understated.
Panel A of Table 3 presents the estimated net tax benefits associated with the trust
preferred-for-traditional preferred transactions. As (1) indicates, we define net tax benefits
as the difference between the present value of the total tax benefits and the direct costs of
the trust preferred issue. We estimate that the present value of the total tax savings
associated with the trust preferred-for-preferred transactions from (2) averages $81 million
or about 33% of the issue size. The large magnitude of the estimated net tax benefits
suggests that the implicit tax costs of tax-disfavored returns at the investor level are not
large relative to the tax benefits derived from interest deductions at the issuer level.
In estimating underwriting fees for the trust preferred issuances, we are able to
identify the net proceeds from the trust preferred issue for 30 of 158 issues. Since we
expect underwriting fees to vary with issue size, we regress these fees on issue size and an
intercept, and we use the coefficients from this regression to estimate underwriting fees for
the remainder of the sample. As Panel A of Table 3 indicates, our sample firms paid

20
An additional indirect cost of issue would include any premium required to retire the existing
preferred stock. We do not include the premium costs in our analysis because we found few
instances where the premium, if any, is disclosed. Exclusion of premium costs would
overstate our estimates of the net tax savings. Based on the magnitude of the identified
premiums relative to issue size and net tax savings, the impact of such premiums, where
present, is not expected to have a significant effect on our estimates.
21
See Zuckerman, G. “Bonds Face New Rival: Preferred” The Wall Street Journal, 12/22/96,
pg. C1. We cannot use the yield on the actual debt retired for two reasons. First, we
frequently can’t identify the actual debt instrument retired. Second, when we can identify a
specific debt issue, it is most often short-term debt for which the yield is not directly
comparable to trust preferreds because of differences in maturities and subordination.

12
 Debt-Equity Hybrid Securities

estimated average underwriting fees of $3.9 million or 1.89% of issue size.22 We also
estimate that firms paid, on average, approximately $5.4 million in the form of a yield
premium in order to use trust preferreds instead of debt. Our estimate of the total direct
cost of the trust preferred issues is therefore approximately $9.3 million (about 4% of the
issue size).
Our estimate of the net tax benefits of the trust preferred issue is $71 million, or
28% of the issue size.23 Modigliani and Miller [1963] document that the upper-bound gain
from leverage is τD where τ is the corporate tax rate and D reflects the face value of debt,
and Miller [1977] documents that the marginal benefits of leverage at the corporate level
can be exactly offset by the disadvantage of debt at the investor level. Miller [1988]
acknowledges that this is a special case, not consistent with existing tax rates and thus,
gains from leverage more plausibly lie somewhere between zero and τD. The net tax
benefits in our sample are significantly different from both the maximum theoretical gain
from leverage of 35% (t= -3.78) and the theoretical minimum of no gain from leverage
(t=16.25). A 95% confidence interval ranges from 25.52% to 31.27% of the issue size.
We also estimate the tax benefits more conservatively using a 12.5% discount rate
rather than our estimate of Rdebt. From Panel A of Table 3, the estimated gross tax savings
under this sensitivity analysis average $54 million, about 22% of the issue size. The
estimated net tax benefit is $46 million (18% of the issue size). Thus, although our
estimate is sensitive to the capitalization factor, even the conservative estimate of total tax
savings is substantial.
In addition to estimating the tax benefits and direct costs of the trust preferred
issues, we also compute the earnings per share (EPS) and leverage ratio effects of
replacing non-deductible preferred stock with tax deductible trust preferred. Trust
preferred dividends are an expense on the income statement, thereby decreasing net income
by the after-tax cost of the trust preferred dividends. Net income available to common
shareholders (i.e., net income less preferred dividends) used in earnings per share
calculations, however, increases by the tax savings relating to the trust preferreds. We
report this latter earnings impact in terms of earnings per share. As Panel A of Table 3
indicates, trust-for-traditional preferred issues increased the sample firms' EPS by 1.59%
on average (replacing traditional preferred stock with trust preferred stock has no impact
on leverage ratios if trust preferred stock is considered to be equity). 24 The increase in

22
This estimate ignores the fact that had firms chosen to retire preferred stock with debt, they
would have incurred an investment banking fee on the debt issue. The Wall Street Journal
(4/1/97 pg. C1) “Bonds, Not Stocks, Keep the Ink in Underwritings Flowing Fast,” reports
that investment banking fees on debt issues are “less than 1% of the offering amount.”
Therefore, our estimate may be overstated by about 1% of the issue size.
23
For the subset of 23 sample firms for which we have effective yields, our estimate of net tax
benefits is approximately $70 million (26% of issue).
24
When estimating the change in earnings per share and leverage resulting from the trust
preferred issue, we used financial data for year t-1 where year t is the year the trust preferred
was issued.

13
 Debt-Equity Hybrid Securities

retained earnings (and assets) due to tax savings from the deductibility of the trust
preferred dividends has an inconsequential effect on debt-to-equity and debt-to-asset ratios.

4.2 ESTIMATES OF THE COSTS OF BALANCE SHEET MANAGEMENT

In this section we use our sample of trust preferred stock to provide evidence that
firms will incur costs to have a security labeled as non-debt for financial reporting
purposes, and we quantify these amounts. This analysis considers the set of firms that
issue trust preferred stock to retire debt; such firms do not generate tax savings, but simply
replace a security that is reported in the debt section of the balance sheet with one that is
not.25 Potential benefits of such balance sheet management may include, among other
things, the equity credit given to trust preferreds by rating agencies, relaxation of debt
covenant constraints, reduction of conventionally defined leverage ratios, or even
reductions in perceived firm risk to the extent that market participants fixate on balance
sheet classification. While it is difficult to place a dollar value on any potential benefits
resulting from a particular label attached to a security in the financial statements, we can
estimate how much firms are willing to pay for the label attached to trust preferred stock.
We estimate the lower-bound of what firms appear willing to pay for the label
associated with trust preferred stock as the direct issue costs and yield premium incurred
by trust preferred-for-debt issuers. These costs are the lower-bound because they reflect
how much firms had to pay for the label associated with trust preferred stock, not the
maximum they would have been willing to pay. We measure the upper-bound as the
forgone tax savings of firms that used trust preferred proceeds to retire debt instead of
outstanding preferred stock. The forgone tax savings are computed in the same manner as
were the tax savings realized by firms that used trust preferred proceeds to retire
traditional preferred stock.
As Table 1 notes, in 63 of the trust preferred transactions, the issuing firm
indicated its intent to retire outstanding debt. Of these firms, 48 involved only debt
recapitalizations (i.e., no retirement of preferred stock) with 44 meeting data requirements
for the analyses in this section.26 Estimates of the direct costs associated with trust
preferred-for-debt exchanges are, on average, of similar dollar magnitude per issue to
those reported for trust preferred-for-traditional preferred exchanges in Panel A of Table

25
The surge in trust preferred issuances after the Federal Reserve Board announcement
documented in Panel A of Table 1 suggests that commercial banks that issue trust preferred
stock to retire debt may be motivated by regulatory benefits as well as, or in place of, financial
reporting benefits. To the extent that this is the case, our measures of what firms are willing
to pay to manage their balance sheets will be overstated. However, sample firms included in
this analysis (i.e., those indicating their intention to use the issue proceeds to retire debt)
include no commercial banks. Sample commercial banks issued trust preferred stock only in
the last quarter of 1996 (i.e., after the Federal Reserve’s Board ruling) with the overwhelming
majority intending to use the proceeds for ‘general corporate purposes’.
26
It is difficult to identify the particular debt issue retired in these transactions. The debt retired
is most often identified as bank debt and the disclosures for non-traded debt are sparse.

14
 Debt-Equity Hybrid Securities

3. Specifically, we estimate that total direct costs in trust preferred-for-debt transactions

average about $10 million. We compute an estimate of the upper-bound for the subset of
15 trust preferred-for-debt issuers that also had outstanding preferred stock and find that
average forgone tax benefits are about $43 million for these firms. Expressed as a percent
of issue size, a 95% confidence interval around the lower bound estimate ranges from
4.14% to 4.31%, while a 95% confidence interval around the upper-bound estimate ranges
from 15.84% to 28.86%. Both estimates are significantly different from zero at
conventional levels.
The $43 million is an upper-bound of the total cost firms appear willing to pay for
balance sheet management, rather than a point estimate, because firms may have also have
been motivated by reducing the costs of financial distress (Sweeney, 1994). Since trust
preferreds are subordinated to debt, issuing trust preferreds and retiring debt should reduce
the probability of financial distress. However, this incentive does not appear applicable to
our sample firms who are for the most part very large, well-established firms (e.g.,
Texaco, Chase Manhattan, Ford). Panel A of Table 2 also documents that average market
values and profitability measures of trust preferred issuers dramatically exceed those of
both traditional preferred issuers and other firms in their respective industries.
We also estimate the financial reporting impact of trust preferred-for-debt
transactions following the same procedures as employed for trust preferred-for-preferred
transactions. As indicated in Panel B of Table 3, the effect on EPS is negligible, but
negative, due to the higher rate paid on trust preferreds over comparably risky debt. We
find that trust preferred-for-debt transactions do, however, result in a 12.8% decrease, on
average, in sample firms’ debt-to-assets ratios.
In summary, estimates in Panel A of Table 3 suggest that firms issuing trust
preferred stock to retire traditional preferred stock generate average net tax benefits of
approximately $71 million (about 28% of the issue size). In addition, these transactions
result in an average 1.59% increase in EPS. Panel B of Table 3 indicates that firms
issuing trust preferreds to retire debt pay between $10 million and $43 million for the
favorable balance sheet label associated with trust preferred issues.

5. Equilibrium Pretax Returns on Trust Preferred Stock and Traditional Preferred

Stock

In this section we use our sample of trust preferred stock issuances to provide
evidence on the extent to which investor level taxation affects the pricing and pretax
returns of securities, by means of implicit taxes.27 Such taxes equal the difference in
pretax returns between a tax-favored asset (e.g., a municipal bond) and the fully-taxed
benchmark asset (e.g., a corporate bond). Despite the apparent simplicity of the concept,
understanding and documenting implicit taxes is difficult. First, empirical measures of

27
See Scholes and Wolfson (1992), Chapters 5 and 6 for a detailed discussion and illustration of
implicit taxes.

15
 Debt-Equity Hybrid Securities

implicit taxes require a control for risk differences between tax-favored and tax-disfavored
assets. Because risk is priced, differences in expected returns between the tax-favored
asset in question and a benchmark fully-taxed asset might be caused by either or both
differences in tax treatment and risk differences.
Second, existence of implicit taxes are complicated by tax clienteles (i.e., investors
facing different tax treatment on the same asset returns). In even a simplified setting with
as few as two differently taxed assets and two differently taxed investors, it is difficult to
determine what equilibrium pretax returns to expect on the two assets. Suppose, for
example, there are two types of investors, individuals and tax-exempt investors, and two
types of assets, corporate and municipal bonds. The following condition must hold for
individuals to be indifferent between corporate and municipal bonds:

Rc (1-tp) = Re (4)

where Rc is the pretax return on the corporate bond, Re is the return on the municipal bond,
and tp is the marginal explicit tax rate faced by the individual investors. However, for the
tax-exempt investors to be indifferent between the two assets, the following condition must
hold:

Rc = Re. (5)

Equations (4) and (5) cannot hold at the same time, except when t=0. Thus, even
in the very simple setting of two differently taxed assets and two differently taxed
investors, the concept of equilibrium becomes complicated. Extending the numbers of
differently taxed assets and differently taxed taxpayers greatly increases the number of
conditions that must hold for equilibrium to occur (Dammon and Green, 1987). Scholes
and Wolfson (1992) show that in the absence of frictions (i.e., transactions costs) and tax-
code restrictions, tax arbitrage will eliminate all taxes in these settings.
In general, the extent to which taxes affect pretax rates of return is an empirical
question. Theory can, however, place bounds on the implicit taxes that can arise. Zero,
the lower bound of the implicit taxes on municipal bonds occurs if the marginal investors
are tax exempt (i.e., (5) holds). If high income individuals are the marginal holders (i.e.,
(4) holds), municipal bonds will bear implicit taxes at the upper bound of tpRc.28 While
high income individuals may hold large amounts of municipal bonds, individuals may not
be the marginal investors. The marginal and the various classes of inframarginal investors
represent different ‘tax clienteles’ in the sense discussed by Scholes and Wolfson.
We compare returns on trust preferred stock, which is fully-taxed to investors,
with returns on traditional preferred stock, which is tax-favored to corporate investors and
fully-taxed to non-corporate investors. As mentioned earlier, corporations can generally
exclude from taxation at least 70% of the dividends received from other corporations.
However, dividends on trust preferred stock are treated as interest for tax purposes. Thus

28
(4) implies that the implicit tax on municipal bonds, Rc - Re, equals Rc - Rc(1-tp) = tpRc.

16
 Debt-Equity Hybrid Securities

corporate investors will be indifferent between holding trust preferred stock and holding
traditional preferred stock if the following condition holds:

Rtrust (1-tc) = Rpref {1 - tc (1-70%)}

(6)

where Rtrust is the pretax return on trust preferred stock, Rpref is the pretax return on
traditional preferred stock and tc is the marginal corporate tax rate. Individuals are taxed
the same on trust preferred and traditional preferred dividends, so they are indifferent
between the two if the following holds:29

Rtrust (1-tp) = Rpref (1-tp) (7)

Together, (6) and (7) determine the upper and lower bounds of the implicit tax
cost of fully-taxable trust preferred stock relative to traditional preferred stock. The lower
bound of zero occurs if tax-exempt and individual investors are the marginal investors
(i.e., (7) holds). The upper bound of Rtrust - Rpref occurs if corporations are the marginal
holders (i.e., (6) holds).30 With the maximum marginal corporate tax rate at 35%, the
upper bound implicit tax cost of trust preferred stock is approximately 27%.
Table 4 presents our estimates of the implicit tax cost associated with issuing trust
preferred stock. Column 1 of Panel A reports that the average pretax return on trust
preferred stock used to retire traditional preferred stock is 8.37%. Given this rate, theory
tells us that traditional preferred stock should yield between 0% and 2.26% [.27(8.37%)],
on average, less than trust preferred. Equivalently, the return on the retired traditional
preferred stock should be between 6.11% (8.37% less 2.26%) and 8.37%, on average. In
fact, we find that the traditional preferred stock retired had an average pretax return of
8.14% (Column 2). The difference between the rate on trust preferred and the stated rate
on the retired preferred suggests an average (median) implicit tax cost of 0.22% (0.45%)
(Column 3), closer to the lower bound than the upper bound. Column 4 reports an average
(median) implicit tax cost, expressed as a tax rate, of 2.33% (5.10%), computed as the
estimated implicit tax cost divided by the rate on the trust preferred for each firm. This
2.33% mean implicit tax cost is significantly less than the 27% upper bound (t= -13.95),
and is not significantly different from the lower bound of zero (t=1.32). A 95% confidence
interval around the implicit tax cost, expressed as a tax rate, ranges from –0.58% to
5.24%. Panel B presents a similar analysis of implicit tax costs using effective tax rates

29
Tax-exempt investors are not taxed on either trust preferred or traditional preferred dividends,
so they are indifferent between the two assets, when Rtrust = Rpref. This equation is equivalent
to (7). Even though individuals and tax-exempt institutions face different marginal tax rates,
their relative marginal tax rates on the income from these two assets are the same, so they
constitute the same tax clientele for this analysis.
30
If (6) holds, then the implicit tax on trust preferred stock, Rtrust - Rpref, equals Rtrust - Rtrust(1-
tc)/(1-.3tc) = Rtrust{1 - (1-tc)/(1-.3tc)}.

17
 Debt-Equity Hybrid Securities

on the retired preferred stock. Inferences are qualitatively similar to those from Panel A,
except that the mean implicit tax cost is now significantly different from zero (t=2.29) and
has a 95% confidence interval ranging from 1.47% to 8.93%. Additional analyses (not
reported) provide no evidence that these implicit tax costs have increased over time.
These implicit tax cost estimates are consistent with results from studies of the
municipal bond market, which consistently report “small” implicit taxes (e.g., Poterba
[1986], Mankiw and Poterba [1996]). The estimates are within the bounds predicted by
theory, and they are computed from directly observed yields on pairs of securities (trust
preferred and traditional preferred) issued by the same firm, having the same risk, but
which are taxed differently.
One implication of these estimates is that the implicit tax cost of providing returns
in a tax-disfavored form is substantially less than the possible tax benefits of deductibility
for high marginal tax rate issuers. This result might also help to explain the lack of
success researchers have had, in general, in documenting implicit taxes. Most settings in
which implicit taxes are likely to play a role are less clean than this one, and if implicit
taxes tend to be small in the first place estimating them becomes that much more difficult.
For example, decades of research has been inconclusive on the question of whether
securities whose returns are mostly tax-favored capital gains have lower pretax returns
than securities whose returns are mostly tax-disfavored dividends.31 Finally, we note that
like several prior studies of implicit taxes, our setting considers publicly traded securities
and it is possible that implicit taxes are larger in less liquid markets. Tax arbitrage by tax-
exempt institutional investors, which would tend to drive down implicit taxes, is likely
more prevalent among publicly-traded securities than among non-traded assets, for which
transactions costs of buying and selling can be large.

6. Conclusions

We use the features of trust preferred stock, securities treated as equity-like for
financial reporting purposes and as debt for tax purposes, to examine several tax and
financial reporting issues. First, we present evidence that firms are willing incur significant
direct and opportunity costs to obtain the favorable balance sheet label associated with
trust preferred securities. Specifically, we find that firms issuing trust preferred stock and
retiring debt paid, on average, $10 million in direct costs and $43 million in opportunity
costs to reduce their conventionally-defined debt-to-assets ratios by an average of 12.8%.
Second, we find that firms issuing trust preferred stock and retiring traditional
preferred stock are able to achieve substantial tax savings, even though trust preferred
stock has a higher pretax cost of capital than traditional preferred stock. We estimate the
present value of these tax savings, net of the costs of issuance, at about $71 million per
issue, or about 28 cents per dollar of trust preferred stock issued. This result suggests that
the net tax benefits of leverage can be quite large, contrary to some prior research.

31
See Black and Scholes [1974], Miller and Scholes [1982], Fama and French [1998], and Lang
and Shackelford [1998].

18
 Debt-Equity Hybrid Securities

Third, we show that the implicit tax cost of trust preferred stock, expressed as a
tax rate, should be between 0% and 27%, depending on the marginal investor in trust
preferred stock. Our estimates indicate that the mean implicit tax cost of trust preferred
stock is about 2.33% (expressed as a tax rate), suggesting that investor-level taxation has
little effect on the equilibrium pricing of these securities.

19
 Debt-Equity Hybrid Securities

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23
 Table 1
Descriptive Data on Trust Preferred Issues
Panel A: Trust Preferred Issues by Quarter/Year and Industry
| ------------------------- Industry ------------------------- | (1)
Utilities Insurance Other Financial Services Other Total
Value Value Value Value Value
Quarter Number ($ Millions) Number ($ Millions) Number ($ Millions) Number ($ Millions) Number ($ Millions)
4th Quarter of 1993 1 $213.80 1 $75.00 0 $0.00 1 $350.00 3 $638.80
1st Quarter of 1994 0 0.00 1 275.00 1 150.00 2 350.00 4 775.00
2nd Quarter of 1994 2 371.30 2 155.00 1 425.00 1 75.00 6 1,026.30
3rd Quarter of 1994 5 477.00 1 200.00 1 200.00 0 0.00 7 877.00
4th Quarter of 1994 4 397.50 0 0.00 0 0.00 1 250.00 5 647.50
1st Quarter of 1995 3 325.00 0 0.00 2 1,017.50 0 0.00 5 1,342.50
2nd Quarter of 1995 2 132.50 1 250.00 2 128.00 3 1,260.00 8 1,770.50
3rd Quarter of 1995 7 955.60 3 835.00 3 675.00 3 1,301.00 16 3,766.60
4th Quarter of 1995 8 910.70 3 327.50 0 0.00 4 1,555.90 15 2,794.10
1st Quarter of 1996 2 125.00 2 250.00 2 1,000.00 3 850.00 9 2,225.00
2nd Quarter of 1996 7 885.00 2 315.00 3 1,000.00 5 2,395.00 17 4,595.00
3rd Quarter of 1996 4 590.00 2 350.00 3 1,125.00 2 123.50 11 2,188.50
4th Quarter of 1996 7 1,075.00 3 1,100.00 33 9,670.00 9 1,890.00 52 13,735.00
Total 52 $6,458.40 21 $4,132.50 51 $15,390.50 34 $10,400.40 158 $36,381.80

Panel B: Trust Preferred Issues by Intended Use of the Proceeds and Industry
| ------------------------- Industry ------------------------- | (1)
Utilities Insurance Other Financial Services Other Total
Value Value Value Value Value
Intended Use (2) Number ($ Millions) Number ($ Millions) Number ($ Millions) Number ($ Millions) Number ($ Millions)
Retire Debt (3) 25 $3,401.10 10 $2,002.50 12 $3,742.50 16 $5,140.00 63 $14,286.10
Retire Preferred (4) 23 3,215.10 2 225.00 15 4,478.00 6 1,891.90 46 9,810.00
General Corporate (5) 20 2,595.80 6 1,375.00 29 8,180.00 9 3,050.00 64 15,200.80
Other (6) 13 1,489.50 7 1,255.00 13 4,590.00 10 2,745.00 43 10,079.50
Total (7) 81 $10,701.5 25 $4,857.5 69 $20,990.5 41 $12,826.9 216 $49,376.4

Notes:
(1) Trust preferred issues are sorted into those that were issued by: (i) utilities (SIC 49), (ii) insurance companies (SIC 63-65), (iii) other financial services (SIC 60-62, 67)
and (iv) all others.
(2) The intended use of the proceeds from the trust preferred issuance was determined from press reports collected from the Lexis/Nexis database. Press reports were based
in part on each firm's stated intentions in security registration documents.
(3) Press reports indicate that the intended use of the proceeds from these trust preferred issuances was at least partly to reduce or redeem outstanding debt.
(4) Press reports indicate that the intended use of the proceeds from these trust preferred issuances was at least partly to retire preferred stock.
(5) This category includes those issues for which the stated use of the proceeds was general corporate purposes, broadly defined.
(6) A number of firms did not specify the intended use of the proceeds. Some firms also indicated proceeds would be used to finance an acquisition or to fund capital
expenditures. All three groups of firms are included in this category.
(7) Does not sum to the total in Panel A because the proceeds from some issues had multiple intended uses (e.g., retire debt and finance capital expenditures).
 Table 2
Descriptive financial information by industry for the sample of trust preferred issuers,
issuers of traditional preferred stock and all Compustat firms during the period 1993-1996

Means (Medians) # of Market value Debt-to- Return on Return on Capital-to- % of firms with
obs. (in millions) Total Assets Assets Equity Total Assets Preferred Stock
Utilities (SIC=49):
Trust preferred issuers 33 $4,098.11 0.318 0.035 0.124 0.318 100%
(1979.49) (0.322) (0.036) (0.129) (0.325)
Traditional preferred stock holders 163 1,960.91 0.324 0.009 0.035 0.302 100%
(942.45) (0.312) (0.037) (0.124) (0.335)
All Compustat firms 293 1,443.32 0.296 0.004 0.006 0.350 56%
(418.31) (0.305) (0.036) (0.116) (0.347)
Insurance carriers (SIC=63):
Trust preferred issuers 20 $3,240.15 0.069 0.016 0.168 0.121 65%
(1,564.09) (0.046) (0.012) (0.149) (0.092)
Traditional preferred stock holders 51 2,427.38 0.049 0.024 0.113 0.195 100%
(1,023.42) (0.033) (0.015) (0.143) (0.138)
All Compustat firms 243 1,765.69 0.049 0.031 0.098 0.288 21%
(337.66) (0.024) (0.025) (0.129) (0.247)
Other financial services (SIC=60 - 62 and 67):
Trust preferred issuers 25 $6,385.86 0.099 0.011 0.158 0.095 84%
(5,258.55) (0.066) (0.011) (0.173) (0.075)
Traditional preferred stock holders 154 3,221.78 0.109 -0.001 0.146 0.116 100%
(577.7) (0.054) (0.010) (0.150) (0.078)
All Compustat firms 928 930.54 0.112 0.003 0.098 0.122 17%
(76.56) (0.042) (0.011) (0.121) (0.094)
Other industries:

Trust preferred issuers1 24 $10,345.32 0.332 0.022 0.014 0.242 58%

(8,217.20) (0.290) (0.030) (0.094) (0.236)
Traditional preferred stock holders 1,127 1,491.91 0.266 -0.157 -0.52 0.228 100%
(57.55) (0.189) (0.011) (0.055) (0.378)
All Compustat firms 6,851 988.92 0.196 -0.056 -0.185 0.392 16%
(79.12) (0.113) (0.031) (0.079) (0.488)

Note: All information for trust preferred issuers is as of the end of the fiscal year preceding the issue. Data for all preferred stock issuers and Compustat firms are as of
the end of fiscal 1995. Market value reflects the market value of common equity. Debt-to-total asset ratio reflects the book value of total long-term debt divided by
total assets. Return on assets reflects the ratio of net income to average total assets. Return on equity reflects the ratio of net income to average book value of common
equity. Capital-to-total assets ratio reflects the sum of the book values of preferred and common equity divided by total assets.

1
Includes firms in 2-digit SIC codes 10 (metal mining), 20 (food products), 21 (tobacco products), 28 (chemical products), 29 (petroleum refining), 36 (electric equipment),
37 (transportation equipment), 45 (air transportation), 48 (communications), 51 (nondurable goods-wholesale), with no 2-digit category having more than nine sample firms.
 Table 3
Analysis of Direct Costs, Tax Benefits, and Financial Reporting Benefits
of Trust Preferred Issuances

Panel A - Trust Preferred Issued to Redeem Outstanding Preferred Stock during 1993-1996 (N = 28)
Standard
Mean Median deviation Minimum Maximum
Issue size ($ millions) $233.11 $136.25 $278.64 $49.70 $1,225.00
Trust preferred yield 8.67% 8.19% 1.12% 7.53% 13.25%
Redeemed preferred stock stated yield 8.14% 7.95% 1.12% 6.50% 12.25%
Redeemed preferred stock effective yield (n=23) 7.89% 7.65% 0.82% 6.50% 9.50%

Total tax benefits

Total tax savings ($ millions) (1) $80.74 $38.93 $96.08 $13.72 $371.92
Total tax savings (% of Issue) 32.65% 30.16% 9.27% 13.72% 59.76%
Sensitivity analysis (2)
Total tax savings ($ millions) (1) $53.99 $26.03 $67.95 $9.41 $288.61
Total tax savings (% of Issue) 21.64% 21.16% 5.80% 9.41% 36.79%

Direct costs ($ millions)

Underwriting spread (3) $3.92 $2.53 $3.98 $1.29 $18.10
Premium paid on trust preferred (4) $5.42 $3.14 $5.98 $1.11 $24.99
Total direct costs $9.34 $5.58 $9.95 $2.41 $42.73
Sensitivity analysis (2)
Underwriting spread (3) $3.92 $2.53 $3.98 $1.29 $18.10
Premium paid on trust preferred (4) $3.64 $2.13 $4.35 $0.78 $19.11
Total direct costs $7.55 $4.66 $8.33 $2.07 $37.21

Net tax benefits

Total tax benefits less direct costs ($ millions) $71.40 $33.84 $86.60 $9.43 $329.19
Total tax benefits less direct costs as % of issue 28.39% 26.46% 9.25% 9.43% 55.68%
Tax benefits as a % of market value of equity (5) 1.16% 0.86% 1.00% 0.13% 4.01%
Sensitivity analysis (2)
Total tax benefits less direct costs ($ millions) $46.44 $21.93 $59.90 $5.84 $251.40
Total tax benefits less direct costs as % of issue 18.19% 17.66% 5.84% 5.84% 33.68%
Tax benefits as a % of market value of equity (5) 0.75% 0.60% 0.66% 0.09% 2.72%

Financial reporting effects

Change in EPS 1.59% 0.97% 1.69% 0.23% 8.68%
Change in debt to assets -0.03% -0.02% 0.03% -0.14% 0.00%

Notes:
(1) Total tax savings computed as the difference between the after tax cash expenditures on redeemed preferred stock and
the after tax expenditures required for the trust preferred issue had the trust preferred been issued at the same yield as
comparably risky debt. See Section 4 of the text for details.
(2) Sensitivity results capitalize future tax savings and direct costs at r=12.5%.
(3) The underwriting spread is the difference between the face value of the issue and the cash proceeds from the issuance.
We estimated this cost as 2.2% of the issue size plus $.897 million and assume that these costs are immediately tax
deductible.
(4) Estimate of the capitalized cost of the additional yield on trust preferred to entice investors into purchasing trust
preferred instead of comparably risky debt.
(5) Estimated percentage of the market value of equity of trust preferred issuers is defined as the net tax benefits divided by
market value of common equity as of the end of fiscal year t-1.
 Sheet2

Table 3
Analysis of Direct Costs, Tax Benefits, and Financial Reporting Benefits
of Trust Preferred Issuances

Panel B - Trust Preferred Issued to Redeem Outstanding Debt during 1993-1996 (N = 44)

Standard
Mean Median deviation Minimum Maximum
Issue size ($ millions) $246.04 $200.00 $156.77 $60.00 $600.00
Trust preferred yield 8.41% 8.44% 0.77% 6.25% 10.00%
Comparably risky debt 8.11% 8.14% 0.77% 5.95% 9.70%
Lower Bound
Direct costs ($ millions)
Underwriting spread (1) $4.10 $3.44 $2.24 $1.44 $9.16
Premium paid on trust preferred (2) $5.95 $4.97 $3.76 $1.33 $15.27
Total direct costs $10.05 $8.51 $5.98 $2.77 $24.44
Direct Costs as a Percent of Issue Size 4.22% 4.17% 0.34% 3.56% 5.10%
Percent of market value of equity (3) -0.36% -0.18% 0.40% -0.03% -1.91%

Sensitivity analysis (3)

Underwriting spread (1) $4.10 $3.44 $2.24 $1.44 $9.16
Premium paid on trust preferred (2) $3.84 $3.12 $2.45 $0.94 $9.36
Total direct costs $7.94 $6.56 $4.69 $2.38 $18.52
Percent of Issue Size (3)
Implied change in market value of equity (3) -0.28% -0.14% 0.31% -0.02% -1.53%

Upper Bound (n = 15)

Net Foregone Tax Savings (4) $43.28 $31.06 $48.72 $0.22 $209.15
Foregone Tax Savings as a Percent of Issue Size 22.35% 19.64% 15.32% 0.08% 59.76%
Net Foregone Tax Savings - Sensitivity analysis (3)
$24.27 $18.00 $24.82 -$1.08 $103.93

Financial reporting effects

Absolute Change in EPS ($0.003) ($0.002) $0.003 ($0.011) ($0.000)
Change in EPS -0.33% -0.14% 0.50% -2.45% -0.02%
Change in debt to assets -12.84% -8.69% 12.07% -48.92% -1.17%
Change in debt to common equity -12.82% -8.68% 12.07% -48.91% -1.17%

Notes:
(1) The underwriting spread is the difference between the face value of the issue and the cash proceeds from the issuance.
We estimated this cost as 2.2% of the issue size plus $.897 million and assume that these costs are immediately tax
deductible.
(2) Estimate of the capitalized cost of the additional yield on trust preferred to entice investors into purchasing trust
preferred instead of comparably risky debt.
(3) Sensitivity results capitalize future tax savings and direct costs at r=12.5%.
(4) Fifteen firms that retired debt with the proceeds from the trust preferred issuance had outstanding preferred
stock. For these fifteen firms, the redemption of outstanding preferred would have generated tax savings.
We compute the amount of these foregone tax savings, net of issue costs and the premium on trust
preferred above comparably risky debt, in the same manner as used in Panel A of this table.

Page 1
 Table 4
Comparison of rates on newly issued trust preferred stock to rates on the preferred
stock retired with the proceeds from the issue and/or directly exchanged for the
newly issued trust preferred during 1993-1996.

Panel A: Based on Stated Rate of Retired Preferred Stock

Rate on New Stated Rate Estimated Estimated Implicit
Trust on Retired Implicit Tax Cost Expressed
Preferred (1) Preferred (2) Tax Cost (3) as a Rate (4)
Mean 8.37% 8.14% 0.22% 2.33%
Median 7.89% 7.95% 0.45% 5.10%
std. dev. 1.12% 1.12% 0.76%
# of obs. 28 28

Panel B: Based on Effective Rate of Retired Preferred Stock

Rate on New Effective Rate Estimated Estimated Implicit
Trust on Retired Implicit Tax Cost Expressed
Preferred (1) Preferred (5) Tax Cost (3) as a Rate (4)
Mean 8.37% 7.89% 0.52% 5.20%
Median 7.89% 7.65% 0.73% 8.00%
std. dev. 1.12% 0.82% 1.07%
# of obs. 28 23

Notes:
(1) Stated rate on newly issued trust preferred stock less .3%. The .3%
controls for the additional premium paid on trust preferred stock to induce
investors to hold this recently developed security.
(2) Stated rate on retired or exchanged traditional preferred stock.
(3) Estimated implicit tax cost is computed as trust preferred rate minus
the rate on the retired traditional preferred stock.
(4) Implicit tax cost as a rate computed as: (trust preferred rate - retired
preferred rate)/trust preferred rate.
(5) Effective rate on retired or exchanged preferred stock. Computed as the
effective yield on the retired or exchanged preferred stock on the date
the trust preferred stock issue was first announced. Source of effective
yields is the S & P Daily Stock Price Guide .