J. K. Dietrich - FBE 432 – Spring, 2002 Module IV: Financial Strategy Dividend Strategy & Hedging Review Week 12 – November 11 and 13, 2002

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


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

Firm

Investment Decision

Dividend Decision

Financing Decision

Capital Markets Goods Markets


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


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


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.


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.


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


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.


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


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


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


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) =


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


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


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


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%


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


Price Exposure in a Diagram

P0 P0

Long

Short

Profit

Loss

0 0

Profit

Loss


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)


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


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


Option Value Sensitivityto Price Changes in Assets

Write Put Write Call

Buy Put Buy Call

S S


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


Replication Futures with Options

P0 P0

LongProfit

Loss

0 0

Profit

Loss

Buy Call

Write Put


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

Documents

J. K. Dietrich - FBE 432 – Spring, 2002 Module IV: Financial Strategy Dividend Strategy & Hedging Review Week 12 – November 11 and 13, 2002