J. K. Dietrich - FBE 532 – Spring, 2006 Module IV: Financial Strategy: Dividend Strategy Week 11...

J. K. Dietrich - FBE 532 – Spring, 2006

Module IV: Financial Strategy:Dividend Strategy

Week 11 – April 4, 2006

2J. K. Dietrich - FBE 532 – Spring, 2006

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


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


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


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


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


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.


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


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.


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


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.


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

DivS

10 gr

DIVP


Summary M-M Debate Issues M-M ISSUES STATE

OF DEBATE CAPITAL STRUCTURE IRRELEVANT

(1) TAXES (2) BANKRUPTCY (3) AGENCY (4) EQUILIBRIUM

TRADEOFFS

DIVIDENDS IRRELEVANT

(1) INFORMATION (2) TAXES (3) MILLER-SCHOLES

EVIDENCE


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


Investment and Dividends

Firms should invest in all NPV>0 projects using the WACC which includes rS

Investment determines a firm’s 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

EquityDividendsIncomeInvestment


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.


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 firm’s rate of return and produce gains New equity dilutes old claims on income


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


Tax Rates on Corporate Income

Bush tax reduction on dividends Equality in taxation?

How to achieve neutrality (0% corporate tax rate)

Dividends Gains InterestDividends and Gains Interest

Corporate Tax Rate 35% 35% 0% 35% 0%Personal Tax Rate 35% 15% 35% 15% 35%

Total Tax 70% 50% 35% 50% 35%

Before After


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.


Ex Dividend Date Price Behavior

Ex Dividend Date

In a friction-free world, $2 is the ex dividend price drop

Stock Price

Declaration Date

Payment Date


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


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.


Dividend Puzzle I

Firm

Firms often borrow money to pay dividends

Capital Markets

Shareholders


Dividend Puzzle II

Paying dividends Increases Shareholder Taxes

Firm A:No Dividends

Capital gains are taxed when stock is sold

Firm B:Dividends

Earnings paid as dividends are taxed now


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


Dividends Create Value Dividends may increase firm value. Why?

– Dividends are signals of profitability (“Cash is king”) since the firm’s 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


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


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


Clientele Effects

Firms attract clienteles based on their dividend policy

Firm A:No Dividends

High Net Worth Individuals

Firm B:

Dividends

Tax Exempt Institutions and Corporations

Low Tax Bracket Individuals


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.


Module V:International Capital Markets

Week 12 -- April 6, 2006


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


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


Example Stock Markets 2001

Source: S&P Stock Market Factbook 2001

Number of Firms

Percent of Global Total

CountryU.S.A. 7,534 $15,104 47.42%Japan 2,561 3,157 9.91%

United Kingdom 1,904 2,577 8.09%France 808 1,447 4.54%

Germany 1022 1,270 3.99%South Korea 1308 172 0.54%

Non-OECDChina 1086 581 1.82%

Taiwan 531 248 0.78%

World Total 35,044 35,346 100.00%

Market Capitalization

(Billions)


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


Recent Findings

Importance of global effects has increased in the “new economy” of the 1990’s

Emerging country specific risk has increased dramatically since the crises of the 1990’s while developed-country specific risk has declined

Industry factors, especially technology, probably explain higher correlations


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


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.)?


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?


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


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


Equity Trading Costs (One-Way Mean, in Basis Points)

AsiaEastEurope

LatinAmerica

OECD

Implicit

Explicit

0

10

20

30

40

50

60

70


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


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


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)


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


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 1980’s

» Institutional investors wishing international diversification

» Foreign firms wishing to raise funds in U.S.

Several levels of ADRs


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)


ADRs on NYSE 2000Country/

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


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?


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


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

J. K. Dietrich - FBE 532 – Spring, 2006 Module IV: Financial Strategy: Dividend Strategy Week 11...

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