Module IV: Financial Strategy: Dividend Strategy

1
Module IV Financial StrategyDividend Strategy

• Week 11 April 4, 2006

2
Objectives

• Learn about the institutional details of
• paying dividends and
• the types of dividends that exist
• Understand the theory of dividend policy
• Examine the factors that actually determine
  dividend policy
• Avon case is requires exploring the above issues

3
Introduction

• The dividend decision is one of the most
  important decisions facing a corporation
• How much of earnings given back to shareholders?
• This is the same decision as how much of earnings
  should be retained

4
Financial Decisions

• Assets are traded in the goods and services
  markets
• The investment decision is main role of financial
  management because goods markets can be
  inefficient
• Liabilities are issued and traded in the
  securities markets
• The financing decision is second requirement of
  financial management but managers face generally
  efficient markets for securities
• Distribution of cash is the final decision
  management must make
• The dividend decision returns resources to owners

5
Types of dividends

• Cash dividends (either regular or extra) are cash
  distributions from earnings and are the most
  common
• Liquidating dividend pay out all cash from sale
  of assets to end operations of the firm
• Stock dividends (issuing new stock as a dividend)
  are like stock splits and are not really what we
  mean by dividends since no cash is paid

6
Other Distributions

• Share repurchases (through the open market or a
  general tender offer) are another way of
  distributing cash to shareholders
• Some cash payments to shareholders are made
  through direct negotiation, e.g., greenmail

7
Institutional Details

• Dividends are set by the board of directors and
  are paid to all recorded shareholders.
• There are typically legal restrictions on
  dividends in order to protect bondholders from
  agency costs.
• Otherwise, firms near bankruptcy could pay
  liquidating dividends from capital, essentially
  transferring wealth from bondholders to
  stockholders.

8
Procedures for Cash Dividends

• Four key Dates
• Declaration Date Board passes a resolution to
  pay dividends to all shareholders of record on a
  certain (payment) date.
• Date of Record Declared dividends are
  distributable to shareholders of record on this
  day
• Dividends are not paid to those the corporation
  does not believe are shareholders

9
Procedures Continued

• Ex Dividend Date Shares become ex dividend on
  the date the seller is entitled to keep the
  dividend
• Under NYSE rules. shares are traded ex dividend
  on and after the fourth business day before the
  record date
• Before the ex dividend date, shares trade cum
  dividend (with the dividend)
• Payment Date Dividends are mailed to
  shareholders of record.

10
Empirical Facts

• In recent years, U.S. corporations have paid over
  half their after-tax profits as dividends.
• Most corporations set a target dividend payout
  ratio.
• Corporations smooth their dividend payments to
  shareholders

11
Empirical Facts

• Managers focus more on changes in dividends than
  on the level of dividends.
• Managers are unwilling to lower dividends.
• Changes in dividends are viewed as reflecting
  changes in long-term profitability.

12
Dividends and Valuation

• In the Gordon dividend growth model, stock price
  is the present value of all future dividends, so
  it appears that an increase in dividends will
  raise firm value
• Critical here is that rS is required return on
  equity and gDiv will be determined by the effects
  of dilution from new equity issues

13
Summary M-M Debate Issues
14
Dividend Policy Theory

• Dividend policy should be chosen because of the
  effect of changes in dividends on share value
• Most people believe that dividends are
  shareholders reward for investing in the firm.
• It seems logical that higher dividends are
  associated with higher firm value
• This intuition can be misleading

15
Investment and Dividends

• Firms should invest in all NPVgt0 projects using
  the WACC which includes rS
• Investment determines a firms value
• Value of firm (with or without debt) depends on
  the value from investments
• Cash dividends may not use up excess cash or may
  increase need for new equity

16
Miller-Modigliani Theory

• Dividend policy is thus the trade-off between
  share repurchases or new issues and dividend
  payment.
• Miller-Modigliani Dividend Irrelevance
  Proposition (1961)
• With perfect capital markets and no taxes, the
  dividend policy of a firm does not affect its
  value.

17
M-M Dividend Irrelevance

• Assumes no taxation and efficient markets
• Stockholders can create cash flows equivalent to
  dividends by selling shares
• Shareholders not needing cash can reinvest
  dividends in stock
• Reinvested earnings (not paid as dividends) grow
  at firms rate of return and produce gains
• New equity dilutes old claims on income

18
Issues in the Dividend Debate

• Taxation of dividends versus capital gains
• Different tax treatments individuals, mutual
  funds, pension funds (clienteles)
• Information in dividends
• Cash payment signals real cash flows
• Smoothing implies information on future cash
• Tax effects may be offset
• Miller-Scholes strategies can eliminate problem

19
Tax Rates on Corporate Income

• Bush tax reduction on dividends
• Equality in taxation?
• How to achieve neutrality (0 corporate tax rate)

20
Stock Prices and Dividends

• In theory, the stock price falls by the amount of
  the dividend on the ex date
• For example, consider a stock selling for 30
  that will pay a 2 dividend tomorrow. If the
  price tomorrow is not 28, there is an arbitrage
  possibility. Say the price will stay at 30. I
  buy the stock now, get the 2 dividend, and then
  sell tomorrow, making an arbitrage profit of 2.
  So, the price tomorrow must be 28.

21
Ex Dividend Date Price Behavior
Ex Dividend Date
Stock Price
In a friction-free world, 2 is the ex dividend
price drop
Declaration Date
Payment Date
22
Dividends and Prices Reality

• Stock prices do fall on the ex dividend date, but
  typically by less than the full amount of the
  dividend. Possible explanations
• Personal taxes may cause a drop by 90-95 of the
  dividend.
• The payment of the dividend may result in
  positive stock price movements

23
Dividend Policy in Practice

• As in the case of capital structure, the M-M
  proposition is important because it focuses
  attention on what is meant by dividend policy,
  and what factors affect the choice of dividends.
  
• In reality, M-M theory cannot explain some
  important puzzles regarding dividend policy.

24
Dividend Puzzle I
Firm
Shareholders
Capital Markets
Firms often borrow money to pay dividends
25
Dividend Puzzle II
Firm A No Dividends
Capital gains are taxed when stock is sold
Firm B Dividends
Earnings paid as dividends are taxed now
Paying dividends Increases Shareholder Taxes
26
Real-World Dividend Policy

• In the real-world, dividend policy seems to
  matter considerably.
• Three views on dividend policy all have adherents
• Dividends are value enhancing
• Dividends are value decreasing
• Small changes in dividend policy have little
  effect

27
Dividends Create Value

• Dividends may increase firm value. Why?
• Dividends are signals of profitability (Cash is
  king) since the firms true value may be
  unobservable.
• Dividends absorb excess cash flow, reducing
  agency costs and managerial waste.
• Dividends attract institutions, broadening the
  shareholder base, increasing liquidity and
  lowering the cost of capital

28
Recent Events and Dividends

• Controversy concerning reported earnings with
  firms providing pro forma earnings based on
  normal operations
• Earnings manipulations using legal and illegal
  accounting methods
• Charles Schwab calling for elimination of tax
  disadvantage of dividends to encourage firms to
  pay cash to investors

29
Evidence for Dividends Value

• Researchers have found a positive relationship
  between price-earnings ratios and
  dividend-earnings ratios.
• This, however, does not mean that dividends cause
  higher stock prices.
• But stock prices do not fall by the full amount
  of the dividend payment

30
Clientele Effects
Firm A No Dividends
High Net Worth Individuals
Tax Exempt Institutions and Corporations
Firm B Dividends
Low Tax Bracket Individuals
Firms attract clienteles based on their dividend
policy
31
Summary of Dividend Policy

• Dividend policy is a crucial strategic decision
  for the firm
• Many aspects of dividend policy are puzzling.
• The available evidence suggests that for most
  firms, small changes in dividend policy have
  little effect.

32
Module VInternational Capital Markets

• Week 12 -- April 6, 2006

33
Objectives

• Understand basics of global capital markets and
  recent developments for corporate financing
  decisions
• Understand how foreign firms raise capital in the
  United States and elsewhere
• Examine factors relevant to firms cost of
  financing in using international sources of
  financing

34
International Cases Context

• The Hostile Bid for Red October
• Russian equity market risks
• Inflation
• Liquidity problems
• Reporting and transparency issues
• Political risk taxation, regulation, favoritism
• Genset Initial Public Offering
• France in 1996

35
Example Stock Markets 2001
Source SP Stock Market Factbook 2001
36
Issues in Global Markets

• Integration of capital markets
• How much or how little do events in one market
  reflect events in other markets
• Expected real returns across markets
• Benefits of diversification
• Risk reduction through correlations of returns
• How to choose portfolio allocations
• Risks of international investing

37
Recent Findings

• Importance of global effects has increased in the
  new economy of the 1990s
• Emerging country specific risk has increased
  dramatically since the crises of the 1990s while
  developed-country specific risk has declined
• Industry factors, especially technology, probably
  explain higher correlations

38
Global Financial Management

• Investment in assets
• Find highest NPV or highest return projects on a
  risk-adjusted basis
• Cash flows measured in purchasing power of owners
  (maximize shareholders wealth!)
• Financing
• Minimize cost of funds on a risk-adjusted basis
• International finance analysis of currency and
  political risks that are unique to foreign
  operations

39
Currency and Political Risk

• Currency risk is variability in cash returns due
  to variations in exchange rates
• For important currencies can be hedged in
  financial markets
• Often can be hedged on the balance sheet by
  operating and financing policies (recall American
  Airlines and Canada and G.E. turbine sales
  examples
• Some currencies cannot be hedged what kind of
  risk is currency risk (systematic, liquidity,
  etc.)?

40
International Capital Flows

• Where are highest real returns to be found in the
  world today?
• Emerging market economies (educated, hard-working
  labor, low capital stocks)
• The United States? (capital inflow, new economy,
  benign business environment)
• Europe? (opening to East, Euro, restructuring)
• Latin America?

41
Determinants of Capital Flows

• Take advantage of higher returns
• Japanese investments in Asian neighbors
• OPEC investments in diversified economies
• Benefits from diversification
• Pension funds and other institutional flows
• Arbitrage risk-return differentials
• Temporary differentials that are expected to go
  away, as from political threats that can be
  managed by diversification

42
Issues in International Investing

• Taxes and/or restrictions of payment of dividends
  or proceeds of sale
• Currency related issues
• Ability to hedge and/or convert cash flows
• Costs of currency hedging and/or conversion
• Currency risk due to economic fundamentals
  (devaluation/revaluation)
• Liquidity and transaction costs

43
Equity Trading Costs (One-Way Mean, in Basis
Points)
44
Emerging Market Equity Issues

• Private equity versus public issues
• Role played by private investors (like venture
  capital)
• Importance of marketability for some investors
• Second board markets
• Examples MOTHERS in Japan, U.S. NASDAQ Small Cap
  markets
• Hong Kong GEMs, Korean Kosdaq, Sesdaq

45
Markets and Venture Capital

• Emerging market economies in Asia have been
  active in developing venture capital industries
• Most successful (like U.S.) is Taiwan
• Others differ from U.S. experience, partially for
  cultural reasons
• Organizational forms and exit possibilities
• Second board markets in Asia have not represented
  a reliable exit strategy

46
Trends in Equity Trading

• Global integration in equity trading
• Natural economies of scale in markets size
  promotes liquidity
• Technology
• History and legal system
• Three models of future markets
• Concentration, as in NYSE in U.S.
• Alliances (e.g. Singapore and Australia)
• Electronic markets (ECNs)

47
Advantages of U.S. Listing

• Liquidity provided by large markets
• Established market with global reputation and
  known and enforced rules of conduct
• Prestige of listing
• Attractiveness to investors
• Domestic U.S. retail investors
• Reporting and currency issues
• Institutional investors
• Liquidity and liability concerns

48
American Depository Receipts

• American depository receipts (ADRs) are used for
  foreign companies to trade on U.S. markets
• Shares deposited in custodial bank in firms home
  countries
• ADRs have grown in popularity since 1980s
• Institutional investors wishing international
  diversification
• Foreign firms wishing to raise funds in U.S.
• Several levels of ADRs

49
Levels of ADRs

• Level I
• Simplest but unlisted and traded over-the-counter
  (pink sheets)
• Reporting requirements are minimal (Form F-6)
• Level II
• Required to list on exchanges (NYSE, AMEX,
  NASDAQ)
• Disclosure but not meeting U.S. standards
• Level III
• Full compliance with U.S. reporting requirements
  (using GAAP standards)

50
ADRs on NYSE 2000
Country/ Region ADR Issues Shares (mill) Volume ( mill) Market Cap ()
China 13 166.5 5,631.0 2,480.3
Japan 13 242.8 22,588.0 10,594.5
S. Korea 5 351.0 15,469.9 6,649.5
Taiwan 4 229.1 14,299.0 2,858.8
Asia 64 2,346.1 920,617.6 45,331.2
Europe 174 9,763.3 514,235.1 399,607.2
L. America 103 3,563.4 141,416.9 79,795.9
51
Who Owns Foreign Corporations?

• SOEs partially privatized
• Shares traded in China
• Ownership by a variety of institutions
• Stakes in firms also owned by
• Regional governments
• Government ministries
• TVEs
• Pension funds and TICs
• Goal of management?

52
Next Week April 13, 2006

• Review topics covered in RWJ, Chapters 1, 14, 20
• Read and think carefully about issues of
  corporate governance in Circon (A) case for
  discussion on April 20 and remember that this is
  the last individual case write-up
• Use week of April 24 to review for final exam by
  reviewing course syllabus, weekly objectives and
  slides, and case notes

53
Next Week April 13, 2006

• Review text material on international capital
  markets (e.g. RWJ, Chapter 31)
• Prepare Genset Initial Public Offering group
  write-up before class for discussion on April 13,
  2006