Module IV: Financial Strategy: Dividend Strategy

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 • 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 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 • 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

Summary M-M Debate Issues

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

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)

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 Stock Price In a friction-free world, $2 is the ex dividend price drop 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 Shareholders Capital Markets Firms often borrow money to pay dividends

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

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 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

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

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)

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 2000

Module IV: Financial Strategy: Dividend Strategy