The Market Impact of Early Debt Redemptions: Evidence from the Consideration of Accounting Gains and Losses

Abstract

The study examines the relationship between accounting gains and losses resulting from early debt redemptions (EDRs) and abnormal returns at the initial announcement of the EDRs. We explore alternative explanations that were omitted from prior literature and test for both income-based and leverage-based explanations for the market's reaction to the EDRs. We find a positive association between the EDR income effect and abnormal returns, and negative relation with both the pre-EDR debt-equity ratio and leverage reduction resulting from the EDRs. We discriminate between alternative explanations using interaction effects between the EDR income and leverage variables. Although the overall results are consistent with the information signaling hypothesis, they also provide mixed support for the contracting hypothesis. Additional evidence indicates that the signaling effect of the EDRs is stronger for smaller firms and EDRs subject to taxes.