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The decision to issue auction rate preferred stock or to redeem an outstanding issue depends partially upon whether the security is the lowest cost source of capital on a risk-adjusted basis.
A well-known risk associated with auction rate preferred stock is the "failure" of an auction.
Here, we hypothesize that the market has been adversely affected by (i) a reduction in the corporate dividends-received-deduction that decreased the tax subsidy to auction rate preferred stock, and (ii) a reduction in the availability of nondebt tax shields (in the form of depreciation write-offs and investment tax credits) that increased the availability of the tax subsidy to debt financing.
A money market instrument yielding ten percent returned 5.4% on an after-tax basis under the tax regime existing at the time auction rate preferred stock was introduced.
In summary, a confluence of changes in the tax code would appear to have increased the relative cost of auction rate preferred stock by (i) decreasing the implicit tax subsidy on preferred dividends and (ii) increasing the explicit tax subsidy to debt financing.
Van Horne's analysis also seems to imply, however, that the benefits of auction rate preferred stock to both purchasers and issuers were initially oversold.
The Dutch Auction Rate Preferred Stock History Quarterly, published by Salomon Brothers, served as the point of origin for the empirical analysis.
Exhibit 2 summarizes select attributes of issue and redemption activity by year in the market for auction rate preferred stock over the period spanning the third quarter of 1984 through the first quarter of 1991.
A breakdown of the 103 issuing companies by industry classification in Panel B shows that fully one-half of the companies issuing auction rate preferred stock were either banks, thrifts or credit companies; the remaining portion of the sample was split evenly between nonbank financial institutions, industrial companies and utilities.