Debt and Equity Characteristics of Mandatorily
Redeemable Preferred Stock
KAM C. CHAN
Department of Business Administration, Jersey City State College, Jersey City, NJ 07305
GIM S. SEOW
School of Business Administration, University of Connecticut, Storrs, CT 06269
Abstract. This study examines whether mandatorily redeemable preferred stock (MRPS) is priced more like
debt or equity by (1) investigating its debt and equity characteristics and (2) specifying conditions under which
one characteristic would dominate the other. Based on a sample of 113 nonconvertible MRPS issued during 1970
to 1990, our results are consistent with the view that MRPS has both debt and equity characteristics. The debt
(equity) feature is more pronounced among nonutility (utility) issues. Within the utility group, we find high (low)
rated MRPS issues to be more debt (equity) like. Our results appear to support current MRPS disclosure rules.
Key words: preferred stock, redeemable, debt, equity
Mandatorily redeemable preferred stock (MRPS) has become an increasingly popular
mode of financing for many corporations and public utilities in recent years. Kimmel and
Warfield (1993) estimate that MRPS constitute about 5.5 percent of total assets for cor-
porations during 1979 to 1989. The primary difference between a MRPS and a regular per-
petual preferred stock is that the former carries a commitment by the issuer to redeem the
issue over a fixed period, usually at a slight premium in the early years and declining to
par or stated value in the terminal year.
In the Financial Accounting Standards Board’s (FASB) conceptual framework, a finan-
cial instrument should be classified as either debt or equity. Clarke and Kahn (1990) and
Nair, Rittenberg, and Weygandt (1990) document various debt and equity characteristics
of MRPS and note its numerous measurement and disclosure problems for financial
reporting. According to the Securities and Exchange Commission’s (SEC) Accounting
Series Release (ASR) No. 268, Redeemable Preferred Stocks, a public company is pro-
hibited from displaying redeemable preferred stock under shareholders’ equity. The effect
of this requirement is to report MRPS under a separate category between debt and equity
on the balance sheet.
The classification of MRPS as debt or equity has practical importance for credit and
financial analysis. Wertheim and Schneider (1992) and Wertheim (1992) discuss how this
classification of MRPS could greatly affect many financial ratios currently used to evalu-
ate firm performance. As required by ASR No. 268, firms have to report two debt-equity
ratios, one assuming MRPS to be debt and the other assuming it to be equity. For firms
with MRPS issues, this introduces ambiguity in the assessment of financial leverage.
Review of Quantitative Finance and Accounting, 8 (1997): 37–49
© 1997 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.