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Module IV: Financial Strategy: Dividend Strategy. Week 11 – April 4, 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

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  • 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
  • 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
Financial Decisions
  • Assets are traded in the goods and services markets
    • The investment decisionis main role of financial management because goods markets can be inefficient
  • Liabilities are issued and traded in the securities markets
    • The financing decisionis 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 decisionreturns resources to owners
types of dividends
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
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
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
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
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
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 facts1
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
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
dividend policy theory
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
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
miller modigliani theory
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
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
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
Tax Rates on Corporate Income
  • Bush tax reduction on dividends
  • Equality in taxation?
  • How to achieve neutrality (0% corporate tax rate)
stock prices and dividends
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 Price Behavior

Ex Dividend Date

Stock Price

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

Declaration Date

Payment Date

dividends and prices reality
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
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
Dividend Puzzle I



Capital Markets

Firms often borrow money to pay dividends

dividend puzzle ii
Dividend Puzzle II

Firm A:

No Dividends

Capital gains are taxed when stock is sold

Firm B:


Earnings paid as dividends are taxed now

Paying dividends Increases Shareholder Taxes

real world dividend policy
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 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
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
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
Clientele Effects

Firm A:

No Dividends

High Net Worth Individuals

Tax Exempt Institutions and Corporations

Firm B:


Low Tax Bracket Individuals

Firms attract clienteles based on their dividend policy

summary of dividend policy
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.
  • 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
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
Example Stock Markets 2001

Source: S&P Stock Market Factbook 2001

issues in global markets
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
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
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 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
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
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
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
emerging market equity issues
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
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
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
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
  • 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
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)
who owns foreign corporations
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
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 20061
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