Transcript Class 2 - University of Southern California

Module IV: Financial Strategy:
Dividend Strategy
Week 11 – April 4, 2006
J. 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
J. K. Dietrich - FBE 532 – Spring, 2006
2
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
J. K. Dietrich - FBE 532 – Spring, 2006
3
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
5
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
J. K. Dietrich - FBE 532 – Spring, 2006
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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.
J. K. Dietrich - FBE 532 – Spring, 2006
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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
J. K. Dietrich - FBE 532 – Spring, 2006
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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.
J. K. Dietrich - FBE 532 – Spring, 2006
9
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
J. K. Dietrich - FBE 532 – Spring, 2006
10
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.
J. K. Dietrich - FBE 532 – Spring, 2006
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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:
DIV1
P0 
rS  g Div
 Critical
here is that rS is required return on
equity and gDiv will be determined by the
effects of dilution from new equity issues
J. K. Dietrich - FBE 532 – Spring, 2006
12
Summary M-M Debate Issues
M-M
ISSUES
CAPITAL
(1) TAXES
STRUCTURE
IRRELEVANT (2) BANKRUPTCY
STATE
OF DEBATE
TRADEOFFS
(3) AGENCY
DIVIDENDS
IRRELEVANT
(4) EQUILIBRIUM
(1) INFORMATION
(2) TAXES
(3) MILLERSCHOLES
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
14
Investment and Dividends
 Firms
should invest in all NPV>0 projects
using the WACC which includes rS
 Investment determines a firm’s value:
Inve stme nt Income Divide nds Equity
 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
J. K. Dietrich - FBE 532 – Spring, 2006
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.
J. K. Dietrich - FBE 532 – Spring, 2006
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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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
Tax Rates on Corporate Income
 Bush
tax reduction on dividends
 Equality in taxation?
Before
Dividends Gains Interest
Corporate Tax Rate
35%
35%
0%
Personal Tax Rate
35%
15%
35%
Total Tax
70%
50%
35%
 How
After
Dividends
and Gains Interest
35%
0%
15%
35%
50%
35%
to achieve neutrality (0% corporate tax rate)
J. K. Dietrich - FBE 532 – Spring, 2006
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.
J. K. Dietrich - FBE 532 – Spring, 2006
20
Ex Dividend Date Price Behavior
Ex Dividend Date
Stock
Price
Declaration Date
In a friction-free
world, $2 is the ex
dividend price drop
Payment Date
J. K. Dietrich - FBE 532 – Spring, 2006
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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
J. K. Dietrich - FBE 532 – Spring, 2006
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.
J. K. Dietrich - FBE 532 – Spring, 2006
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Dividend Puzzle I
Capital
Markets
Firm
Shareholders
Firms often borrow money to pay dividends
J. K. Dietrich - FBE 532 – Spring, 2006
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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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
26
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
29
Clientele Effects
High Net Worth
Individuals
Firm A:
No Dividends
Tax Exempt
Institutions and
Corporations
Firm B:
Low Tax Bracket
Individuals
Dividends
Firms attract clienteles based on their dividend policy
J. K. Dietrich - FBE 532 – Spring, 2006
30
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.
J. K. Dietrich - FBE 532 – Spring, 2006
31
Module V:
International Capital Markets
Week 12 -- April 6, 2006
J. K. Dietrich - FBE 532 – Spring, 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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
Example Stock Markets 2001
Number of
Firms
Market
Capitalization Percent of Global
(Billions)
Total
Country
U.S.A.
Japan
United Kingdom
France
Germany
South Korea
7,534
2,561
1,904
808
1022
1308
$15,104
3,157
2,577
1,447
1,270
172
47.42%
9.91%
8.09%
4.54%
3.99%
0.54%
Non-OECD
China
Taiwan
1086
531
581
248
1.82%
0.78%
World Total
35,044
35,346
Source: S&P Stock Market Factbook 2001
J. K. Dietrich - FBE 532 – Spring, 2006
100.00%
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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.)?
J. K. Dietrich - FBE 532 – Spring, 2006
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?
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
and transaction costs
Equity Trading Costs
(One-Way Mean, in Basis Points)
70
60
50
40
30
20
10
Implicit
0
OECD
Latin
America
J. K. Dietrich - FBE 532 – Spring, 2006
Explicit
East
Europe
Asia
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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)
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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
J. K. Dietrich - FBE 532 – Spring, 2006
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)
J. K. Dietrich - FBE 532 – Spring, 2006
ADRs on NYSE 2000
Country/
Region
China
Japan
S. Korea
Taiwan
Asia
Europe
L. America
ADR
Issues
13
13
5
4
64
174
103
J. K. Dietrich - FBE 532 – Spring, 2006
Shares Volume Market Cap
($)
(mill)
($ mill)
166.5
5,631.0
2,480.3
242.8 22,588.0
10,594.5
351.0 15,469.9
6,649.5
229.1 14,299.0
2,858.8
2,346.1 920,617.6 45,331.2
9,763.3 514,235.1 399,607.2
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?
J. K. Dietrich - FBE 532 – Spring, 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
J. K. Dietrich - FBE 532 – Spring, 2006
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