Evidence on the role of taxes on financing choice: Considera

A study examines the effect of firms' marginal tax rates on incremental and overall reliance on mandatorily redeemable preferred stock (MRPS). Similarities in the cash flows associated with debt and MRPS, as well as similarities in the claims of holders of the debt and MRPS on the assets of issuing firms, suggest that MRPS may be viewed as a substitute for debt. However, important differences in the tax treatment of MRPS and debt suggest that firms that cannot make full use of interest tax shields may be able to finance more efficiently using MRPS instead of debt. The results indicate that, both incrementally and overall, firms with low marginal tax rates rely more heavily on MRPS than debt relative to firms with high tax rates. This finding is consistent with the proposition that firms that cannot make full use of interest tax shields finance incrementally using equity rather than debt.