Module IV: Financial Strategy Dividend Strategy

1
Module IV Financial StrategyDividend Strategy
Hedging Review

• Week 12 November 11 and 13, 2002

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
Goods Markets
Capital Markets
Firm
Dividend Decision
Investment Decision
Financing Decision
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
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.

20
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
21
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

22
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.

23
Dividend Puzzle I
Firm
Shareholders
Capital Markets
Firms often borrow money to pay dividends
24
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
25
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

26
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

27
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

28
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

29
Dividends Reduce Value

• Dividends may decrease firm value. Why?
• Dividends are taxed twice, once at the corporate
  level and once at the personal level.
• Dividends reduce internal sources of funding,
  possibly forcing the company to forgo positive
  NPV projects or rely on external equity
  financing.
• Dividends reduce managerial flexibility.

30
Dividends Value-Reducing Facts

• Prior to the 1986 tax reform, this favored
  payouts through capital gains, i.e., share
  repurchase, so dividends lower firm value.
• Even under the current tax code, investors should
  prefer to receive income in the form of capital
  gains. However, there are legal restrictions on
  the amount of share repurchase.
• Yet firms pay dividends, and there were no big
  changes in payout ratios around 1986.

31
Middle Position

• No firm can gain or lose by changing its
  dividends at the margin.
• Clientele effects some firms with high payout
  ratios attract investors in low or zero effective
  tax brackets while firms with low payout ratios
  attract investors in high tax brackets.
• The arguments that dividends increase or decrease
  value may offset each other.
• Empirical evidence supports this position

32
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
33
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.

34
Risk Management (Encore)

• Review duration and show how to calculate for
  bonds
• Apply duration concept to fixed assets and
  discuss reasonableness of estimates
• Demonstrate how to use futures and options to
  hedge interest-rate risk
• Show how arbitrage works to keep derivative
  prices in line

35
Duration Calculator
36
Portfolio Duration
37
Example of How Duration Works
38
Duration of Fixed Assets

• Asset cash flows must be projected
• Macauleys duration measure must be used
• Example net cash flows growing at 5 for five
  years and cash sale at 10 times final year cash
  flow, discounted at 12

39
Fixed Asset Duration Issues

• Depends on operating projections and may be
  speculative
• Duration depends on assumption of forecast period
  and continuing value period
• Possible to use simple formulas in case of
  constant growth rates and discount rates
• In example d 16, but is this meaningful?

40
Portfolio Duration and Hedging
41
Hedging Using Futures

• Portfolio is a long position with duration (price
  sensitivity) of 8.4
• CBOT December 2002 Treasury note futures quoted
  on November 6, 2002, at 113-27 or 1.1384375
• Corresponds to a 10-year U.S. note
• Notional coupon rate of 6
• Price corresponds to yield of 5.4953

42
10-Year Note Futures Contract

• Using price of 10327 and corresponding yield of
  5.4953 and contract specified 6 coupon and
  10-year maturity, futures contract has a duration
  of 7.855
• Our portfolio has duration of 8.374
• We could hedge our price exposure by going short
  15mm/100m150 contracts
• Futures profits/losses offset long positions
  losses/gains

43
Price Exposure in a Diagram
Profit
Profit
Long
0
0
P0
P0
Loss
Loss
Short
44
Change in Portfolio Value
Valued on November 7, 2002 (one day after
purchase)
45
Example of Futures Hedge

• Gain on portfolio is 225,562
• Futures contract closed November 7, 2002 at
  114-25 1.1478125
• Loss on futures contract is (1.1384375
  -1.14785)100,000150 141,187.50
• Net gain should be zero but is 84,375
• Departure from zero due to basis risk
• Basis risk due to futures duration not same as
  portfolio duration and interest rate shift not
  parallel

46
Example of Options Hedge

• We are long and wish to protect ourselves against
  downward movement in prices (upward move in
  interest rates)
• Could hedge with a put option on 10-year note
  futures
• We are still exposed to basis risk because of
  difference in duration of futures contract and
  our portfolio

47
Option Value Sensitivityto Price Changes in
Assets
Buy Call
Buy Put
S
S
Write Call
Write Put
48
Put Option Hedge

• 113 December 2002 Treasury note put option on
  November 6, 2002, is priced at 13/64 .002031
• Again choose 150 100,000 contracts, put option
  price is .002031150100000 30,468.75
• On November 7, 2002, put option price fell to
  10/64 .001563 meaning a loss of 7,031.25 on
  put
• We will only exercise put if prices go down
• Put is like insurance on asset prices

49
Replication Futures with Options
Profit
Profit
Buy Call
Long
0
0
P0
P0
Loss
Loss
Write Put
50
Next Week Nov. 11 13, 2002

• Review text material on international capital
  markets (e.g. RWJ, Chapter 32)
• Read Madhavan article
• Write up your analysis of the Avon Case to hand
  in on Tuesday, Nov. 11, 2002
• Prepare Huaneng Power International group
  write-up before class for discussion on Nov. 18,
  2002