J. K. Dietrich - FBE 432 – Spring, 2002 Module IV: Financial Strategy Dividend Strategy & Hedging...
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Transcript of J. K. Dietrich - FBE 432 – Spring, 2002 Module IV: Financial Strategy Dividend Strategy & Hedging...
J. K. Dietrich - FBE 432 – Spring, 2002
Module IV: Financial StrategyDividend Strategy& Hedging Review
Week 12 – November 11 and 13, 2002
2J. K. Dietrich - FBE 432 – Spring, 2002
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
3J. K. Dietrich - FBE 432 – Spring, 2002
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 432 – Spring, 2002
Financial Decisions
Firm
Investment Decision
Dividend Decision
Financing Decision
Capital Markets Goods Markets
5J. K. Dietrich - FBE 432 – Spring, 2002
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
6J. K. Dietrich - FBE 432 – Spring, 2002
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
7J. K. Dietrich - FBE 432 – Spring, 2002
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.
8J. K. Dietrich - FBE 432 – Spring, 2002
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
9J. K. Dietrich - FBE 432 – Spring, 2002
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.
10J. K. Dietrich - FBE 432 – Spring, 2002
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
11J. K. Dietrich - FBE 432 – Spring, 2002
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.
12J. K. Dietrich - FBE 432 – Spring, 2002
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
J. K. Dietrich - FBE 432 – Spring, 2002
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
14J. K. Dietrich - FBE 432 – Spring, 2002
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 432 – Spring, 2002
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
16J. K. Dietrich - FBE 432 – Spring, 2002
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 432 – Spring, 2002
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 432 – Spring, 2002
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
19J. K. Dietrich - FBE 432 – Spring, 2002
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.
20J. K. Dietrich - FBE 432 – Spring, 2002
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
21J. K. Dietrich - FBE 432 – Spring, 2002
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
22J. K. Dietrich - FBE 432 – Spring, 2002
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.
23J. K. Dietrich - FBE 432 – Spring, 2002
Dividend Puzzle I
Firm
Firms often borrow money to pay dividends
Capital Markets
Shareholders
24J. K. Dietrich - FBE 432 – Spring, 2002
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
25J. K. Dietrich - FBE 432 – Spring, 2002
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
26J. K. Dietrich - FBE 432 – Spring, 2002
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 432 – Spring, 2002
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
28J. K. Dietrich - FBE 432 – Spring, 2002
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
29J. K. Dietrich - FBE 432 – Spring, 2002
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.
30J. K. Dietrich - FBE 432 – Spring, 2002
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.
31J. K. Dietrich - FBE 432 – Spring, 2002
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
32J. K. Dietrich - FBE 432 – Spring, 2002
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
33J. K. Dietrich - FBE 432 – Spring, 2002
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 432 – Spring, 2002
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
J. K. Dietrich - FBE 432 – Spring, 2002
Duration CalculatorDuration Calculation J. K. Dietrich - 2002Coupon BondsFormula:
Calculation: i = 10.0%
M= 10 d1 = 6.759
p = 1.0000c = 10.0%
Level Payment LoansFormula
Calculation i = 10.00%
M= 30 d1 = 9.1762
1M)i1(
1cM
pi
1M
i
i1d
1)i1(
M
i
i1d
M
J. K. Dietrich - FBE 432 – Spring, 2002
Portfolio DurationCalculation of Portfolio DurationAsset Market Value Duration Portfolio Weight Weighted DurationAsset 1 10,000$ 6 21.74% 1.304 Asset 2 15,000 3 32.61% 0.978 Asset 3 10,000 2 21.74% 0.435 Asset 4 5,000 7 10.87% 0.761 Asset 5 6,000 9 13.04% 1.174 Asset 6 0.00% - Asset 7 0.00% - Asset 8 0.00% - Asset 9 0.00% - Asset 10 0.00% - Total Portfolio 46,000$ 100.00% 4.652
J. K. Dietrich - FBE 432 – Spring, 2002
Example of How Duration WorksExample: U.S. Treasury 5.375 Feb 31 on Wednesday, November 6, 2002
Calculation of duration:c Mat. Date M p I
5.375% Feb-31 28.25 1.0446875 5.07% d1 = 15.40
4.88%0.19%
0.02909201.075625
0.03093750.177%
Actual price = Change in price =
Error (from approximation and Convexity) =
Duration
Yield on November 7, 2002 =Change in yield from November 6 to 7, 2002 =
Expected change in price (using duration) =
J. K. Dietrich - FBE 432 – Spring, 2002
Duration of Fixed Assets
Asset cash flows must be projected Macauley’s 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%:
Year 1 2 3 4 5Operating Cash Flow 100$ 105$ 110$ 116$ 122$
Sales 1,216$ Total Cash Flow 100$ 105$ 110$ 116$ 1,337$
PV Cash Flow @ 12% = $1,084PV Cash Flow * Payment Period = 89.29 167.41 235.42 294.28 3793.41
Macauley's Duration = 4.23
J. K. Dietrich - FBE 432 – Spring, 2002
Fixed Asset Duration Issues Depends on operating projections and may
be speculative Duration depends on assumption of forecast
period and continuing value period Possible to use simple formulas in case of
constant growth rates and discount rates:
In example d = 16, but is this meaningful?
gr
r1d1
J. K. Dietrich - FBE 432 – Spring, 2002
Portfolio Duration and HedgingCalculation of Portfolio DurationAsset Market Value Duration Portfolio Weight Weighted Duration5.375 Feb-31 UST 5,223,438$ 15.40 34.31% 5.284 3.00 Nov-07 UST 10,001,000 4.70 65.69% 3.091
Total Portfolio 15,224,438$ 100.00% 8.374
J. K. Dietrich - FBE 432 – Spring, 2002
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%:
Price Yield10-Year U.S. Treasury Note
103.270 5.4953%
J. K. Dietrich - FBE 432 – Spring, 2002
10-Year Note Futures Contract Using price of 103:27 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/$100m=150 contracts Futures profits/losses offset long position’s
losses/gains
J. K. Dietrich - FBE 432 – Spring, 2002
Price Exposure in a Diagram
P0 P0
Long
Short
Profit
Loss
0 0
Profit
Loss
J. K. Dietrich - FBE 432 – Spring, 2002
Change in Portfolio ValueCalculation of Portfolio DurationAsset Market Value Duration Portfolio Weight Weighted Duration5.375 Feb-31 UST 5,378,125$ 15.40 34.81% 5.361 3.00 Nov-07 UST 10,071,875 4.70 65.19% 3.067
Total Portfolio 15,450,000$ 100.00% 8.428
Cost 15,224,438$ Value 15,450,000$ Gain 225,562$
% Gain 1.482%
Valued on November 7, 2002 (one day after purchase)
J. K. Dietrich - FBE 432 – Spring, 2002
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)*$100,000*150 = $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
J. K. Dietrich - FBE 432 – Spring, 2002
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
J. K. Dietrich - FBE 432 – Spring, 2002
Option Value Sensitivityto Price Changes in Assets
Write Put Write Call
Buy Put Buy Call
S S
J. K. Dietrich - FBE 432 – Spring, 2002
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 .002031*150*100000 = $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
J. K. Dietrich - FBE 432 – Spring, 2002
Replication Futures with Options
P0 P0
LongProfit
Loss
0 0
Profit
Loss
Buy Call
Write Put
J. K. Dietrich - FBE 432 – Spring, 2002
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