Finance Lecture10

MBAM 614 Finance Dividend Policy II • MBAM614 Class 10 - 1 Summary of Last Class 1. In a world with taxes and other market imperfections, changing the capital structure of a firm does affect firm value 2. Bankruptcy costs and market imperfections give rise to an optimal capital structure where firm value is maximized and WACC is minimized. this structure is almost certainly not all debt. 3. Corporate tax rates, business risk, and nature of assets all play a role in determining the optimal capital structure 4. Dividend Policy should be irrelevant since investors can create whatever payment pattern they like by buying and selling stock. • MBAM614 Class 10 - 2 1 Agenda 1. 2. 3. 4. Dividend Policy and the Real World Establishing a Dividend Policy Share Repurchases Stock Dividends and Splits • MBAM614 Class 10 - 3 Dividends, the Real World & Low Payouts Arguments so far have ignored market imperfections like flotation/commission costs and taxes If corporations are taxed at a lower rate than individuals, there may be an incentive to let firms retain cash for re-investment as a tax management strategy If dividends and capital gains are taxed differently for individuals, one form of return will be favored over the other by investors – basically, investors are interested in risk-adjusted after-tax returns – in the U.S., dividends are presently taxed at a higher rate for individuals evidence suggests that individuals require higher before-tax returns on high dividend stocks • MBAM614 Class 10 - 4 2 Dividends, the Real World & Low Payouts Flotation costs restrict the ability of firms to follow our example of selling equity to pay dividends – high flotation cost reduces value When a firm issues debt, the riskiness of that debt depends, in part, on the total equity of the firm – high dividends reduce total equity – high dividends increase riskiness of debt (thereby reducing the value of debt and transferring it to the equity holders) – as a result, most bond contracts (indentures) contain clauses (covenants) that restrict high dividend payouts dividend policy may affect ability to borrow money • MBAM614 Class 10 - 5 Dividends, the Real World & High Payouts In the real world, there are costs associated with buying and selling stock. This reduces our ability to manufacture dividends – this applies in reverse, too. If some people want low dividends, they incur transaction costs “unmaking” high dividends Individuals are not the only investors affected by taxes – U.S. corporations enjoy a 70% exclusion from taxable income on dividends from other U.S. corporations – pension, endowment, and trust funds are tax exempt (or tax deferred). Many funds are not allowed to spend principal so they rely on dividend income – institutions and funds make up roughly 2/3 of the market’s volume • MBAM614 Class 10 - 6 3 The “Bird-in-the-Hand” Fallacy t=0 P0 1 D1 2 D2 3 D3 P0 = D1/(1+R1) + D2/(1+R2) 2 + D3/(1+R3) 3 + ... Reasoning is since D3 is considerably further off than D1, there is greater uncertainty and thus, greater risk and so R3 > R1. Thus, increasing D1 and decreasing D3 should increase P0. Investors can still create the “bird-in-hand” by selling stock now Uncertainty over future income (business risk) is unaffected by dividend policy Financial risk introduced by borrowing to pay a higher D1 will reduce the value of future dividends offsetting the increase in D1. • MBAM614 Class 10 - 7 Dividend Policy in the Real World There seem to be some factors favoring high payouts and other factors favoring low payouts. In practice, we find a range of payouts. Does this make sense? Consider two firms with the same systematic risk (so same Re) but different dividend policies. – A has high payout so low growth – B has low payout, re-invests, so high growth From the CGM: Re = D1 / P0 + g A’s return is mainly from dividend yield B’s return is mainly from capital gains • MBAM614 Class 10 - 8 4 Clientele Effect Investors will form two clienteles: – People who prefer dividends will choose firm A – People who prefer capital gains will choose firm B Both groups take on the same systematic risk so both earn the same return: Re (just in different forms) Investors select firms with a suitable combination of systematic risk and dividend policy to meet their needs This is called the Clientele Effect • MBAM614 Class 10 - 9 Clientele Effect Because there are many different investors with many different needs and risk tolerances, there will be a clientele for any combination If a firm changes its dividend policy, this reasoning suggests that its clientele would change Because Re doesn’t change, the share price shouldn’t change Implication is that there should be a flurry of trading as people who don’t want the new policy sell and those who do want it buy but prices shouldn’t change There is evidence that trading volume increases around days when firms announce changes in dividend policy • MBAM614 Class 10 - 10 5 Dividend Policy Problems Regardless of theoretical arguments that Dividend Policy is irrelevant, firms spend expensive resources managing it Furthermore, share prices often react to changes in dividend policy: – share prices tend to rise when dividend increases are announced – share prices tend to fall when dividend decreases are announced Seems to imply people prefer high dividend payouts • MBAM614 Class 10 - 11 Dividend Signaling Investor behavior is consistent with belief that dividend changes contain information In practice, managers are very reluctant to decrease dividends for fear of upsetting shareholders – management only reduces dividend if it is unlikely they can sustain it in the future – investors adjust their estimates of future earnings downward Share Price = PV(Future Earnings) declines – similarly, increase only occurs if it is sustainable leads to an upward revision in earnings estimates and an increase in share price Management uses dividend changes to “signal” changes in the firm’s prospects • MBAM614 Class 10 - 12 6 Example: Dividend Signaling To illustrate the importance of not cutting dividends, consider the case of Unisys (the computer firm created by the merger of Burroughs and Sperry corporations). In the last week of September, 1990, Unisys announced it was suspending payment of its regular quarterly dividend (which had been 25¢ a share). The pre-merger companies had a record of over 100 years of regular dividend payments. On the day of the announcement, the stock fell by 23% to a 52 week low. This was the largest decline of any Big-Board traded security that day. • MBAM614 Class 10 - 13 The Residual Dividend Policy Since dividends are paid from earnings, one approach is to pay whatever is not needed out as a dividend – find net cash flow – pay bills – invest in all positive NPV investments using the firm’s target capital structure – residual cash flow gets paid out as a dividend Eg. Your firm is considering the payment of a cash dividend to each of its 2,000,000 shares. Projected net income is $2,000,000, capital projects costing $2,600,000 are planned for this year and the company’s target D/E ratio is 2/3. Can your firm afford a dividend and if so, how much? • MBAM614 Class 10 - 14 7 Example: Residual Dividend Policy New Equity Available All of the $2,000,000 NI could be retained as new equity. In particular, this is the maximum amount of new equity the firm can use without having to issue new shares. Target Capital Structure D/E = 2/3 so E/V = 60% and D/V = 40% For every $1 spent on new investments, $0.60 will be new equity and $0.40 will be new debt if the target capital structure is to be maintained • MBAM614 Class 10 - 15 Example: Residual Dividend Policy Maximum Capital Investment without Issuing New Equity Since every $1 of capital investment requires $0.60 of new equity and we have $2,000,000 new equity available, we can spend up to $2,000,000/60% or $3,333,333. Since this is more than the planned $2,600,000, we will have some earnings left over. New Equity Required 60% of the capital investment will be equity so required new equity is ($2,600,000 × 60%) or $1,560,000 Dividend The remaining $440,000 is paid as a $0.22 per share dividend • MBAM614 Class 10 - 16 8 Consequences of a Residual Policy High growth firms typically have many positive NPV opportunities, tend to re-invest earnings and so have low or no dividends (seen in practice all the time) Low growth firms have fewer positive NPV projects so tend to pay higher dividends In either case (except when there is no dividend), the size of the dividend depends on earnings which can be volatile – shouldn’t matter since business risk and expectations don’t change – many managers believe volatile dividends are very BAD – believe investors want stable dividends (implied information?) A compromise is needed • MBAM614 Class 10 - 17 A Compromise Dividend Policy Ranked in order of decreasing importance, the objectives of a practical dividend policy are: Would reduce 1. Avoid rejecting NPV > 0 projects 2. Avoid cutting dividends 3. Avoid issuing new equity 4. Maintain a target debt/equity ratio 5. Maintain a target dividend payout ratio Nice touch and increases confidence value of the firm Sends negative signal & upsets shareholders Flotation costs are lost Long term in particular • MBAM614 Class 10 - 18 9 Stock Repurchase Instead of paying a cash dividend, a firm may use the money to buy back some of its shares. This is called a Stock Repurchase Similar to homemade dividends in that investors can decide whether they want the “dividend” or not Ignoring taxes and other imperfections, the cash distributed through either method and the value of outstanding shares afterward is the same • MBAM614 Class 10 - 19 Example: Stock Repurchase Deer River Industrial Products has 50,000 shares outstanding and the following market value balance sheet: Market Value Balance Sheet $ 100,000 Debt $ 0 900,000 Equity 1,000,000 $1,000,000 Total Liab & E $1,000,000 Cash Other Assets Total Assets Price per share is $20, Net Income is $100,000, EPS is $2.00, and the P/E ratio is 10. Assuming no taxes, commissions, or other imperfections, the firm is considering: a) paying a $1 cash dividend or; b) repurchasing 2,500 shares at $20 per share • MBAM614 Class 10 - 20 10 Example: DRIP Pays a Dividend Market Value Balance Sheet After Dividend Cash $ 50,000 Debt $ 0 Other Assets 900,000 Equity 950,000 Total Assets $ 950,000 Total Liab & E $ 950,000 $50,000 dividend paid from Cash Reduces Equity by $50,000 Price per Share = ($950,000/50,000) = $19 NI = $100,000 EPS = NI/# Shares = $100,000/50,000 = $2.00/share P/E ratio = Price/EPS = $19/$2 = 9.5 (down from 10) Total value per share = $19 share price + $1 dividend = $20 • MBAM614 Class 10 - 21 Example: DRIP Repurchases Shares Market Value Balance Sheet After Repurchase Cash $ 50,000 Debt $ 0 Other Assets 900,000 Equity 950,000 Total Assets $ 950,000 Total Liab & E $ 950,000 $50,000 repurchase paid from Cash Reduces Equity by $50,000 and Shares Outstanding by 2,500 Price per Share = ($950,000/47,500) = $20 NI = $100,000 EPS = NI/# Shares = $100,000/47,500 = $2.10/share P/E ratio = Price/EPS = $20/$2.10 = 9.5 (down from 10) Total value per share = $20 share price • MBAM614 Class 10 - 22 11 Repurchases in the Real World Most important difference between a dividend and a repurchase is the tax treatment – entire cash dividend is taxable – only the capital gain (price - basis) is taxable – capital gain is taxed at a lower rate for certain individuals No shareholder is forced to take the repurchase and realize a gain However, there are commissions on repurchases, especially for individuals • MBAM614 Class 10 - 23 Stock Dividends Dividends paid in stock rather than cash are called Stock Dividends – expressed as a percentage of shares per share Eg. a 20% stock dividend means 1 additional share is sent to each shareholder for every 5 existing shares owned – since earnings and total equity don’t change, just the number of shares, share price will decline proportionally Eg. CMP is all-equity financed and has 100,000 shares outstanding with a market value of $18 each. The total market value before a stock dividend of 20% is $1,800,000. After the stock dividend, CMP has the same earnings and thus, market value, but the number of shares outstanding is 120,000. Price per share will be $1,800,000/120,000 = $15 • MBAM614 Class 10 - 24 12 Stock Splits Stock Splits are similar to stock dividends – expressed as a ratio of new shares for old Eg. a 2-for-1 stock split means 2 new shares are sent to each shareholder for every existing share owned – an entirely new type of share is created and distributed: old shares are destroyed – a stock dividend is usually 25% or less; otherwise it’s a split – as with stock dividends, nothing changes but the number of shares outstanding so share price will change proportionally – a ratio of less than 1.0, eg. 0.5-for-1, is called a reverse split or consolidation – Stock dividends and splits have different accounting treatments. Neither is taxed in the U.S. • MBAM614 Class 10 - 25 Reasons for Splits & Stock Dividends Generally, there is a cost associated with a split or stock dividend even if it is only mailing out new shares If it doesn’t increase share value (and it might even decrease it), why do it? One argument in favor is that stocks have a popular trading range of prices – a round lot is 100 shares for most stocks – round lot commissions are lower – high share prices make round lots expensive and difficult for investors to afford – doesn’t really make sense given that 2/3 are large funds • MBAM614 Class 10 - 26 13 Reasons for Reverse Splits Popular Reasons – reduces trading transactions costs – “popular trading range” but arguing that prices can be too low – respectability - want to avoid the “penny stock” label Technical reasons – exchange minimum price requirements – “squeeze out” small shareholders • MBAM614 Class 10 - 27 Key Points 1. In practice, market imperfections create clienteles for different dividend policies. Overall, dividend policy still should not affect the value of the firm. 2. If dividends are used to signal changes in future prospects, firm value will give the illusion of responding to dividend policy. 3. Stock dividends and splits are just ways of repackaging what current shareholders already own. • MBAM614 Class 10 - 28 14 MBAM 614 Finance Cash & Liquidity Management • MBAM614 Class 10 - 29 Agenda 1. 2. 3. 4. 5. Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash • MBAM614 Class 10 - 30 15 Cash Management Have discussed reasons for investing in long term assets, how to choose them, and how to finance them The day-to-day operations of a company give rise to short term assets (cash, A/R, inventories, etc.) and liabilities (A/P, bank loans, etc.) Since assets must be financed, short term assets have a cost which must be balanced against the “stock-out” cost of running out - this is Current Asset Management Easy to see why we need A/R and inventories, but what about cash? • MBAM614 Class 10 - 31 Reasons For Holding Cash Three reasons usually given: – Speculative Motive is to make it possible to take advantage of unexpected opportunities – Precautionary Motive is to guard against the occasional unexpected cost or outlay – Transaction Motive arises because cash inflows and cash outflows are not perfectly synchronized Cash balance serves as a buffer between collections and disbursements • MBAM614 Class 10 - 32 16 Substitutes for Cash Speculative Motive and Precautionary Motive really require an ability to pay quickly – this can be met with liquidity (easily saleable assets) – cash is most liquid asset – certain marketable securities are a close second so they are close substitutes for cash – an ability to borrow quickly is also a close substitute • MBAM614 Class 10 - 33 Cash Management Process Cash management has three steps: – Determining the target cash balance – Collecting and disbursing cash efficiently – Investing “excess” cash • MBAM614 Class 10 - 34 17 Target Cash Balance The Target Cash Balance is a trade-off between carrying costs of cash and shortage costs. Carrying Cost of cash is opportunity cost of holding cash balances (returns on other potential investments) Adjustment Costs are costs associated with holding low levels of cash - they are shortage costs – cost of converting other assets into cash if a firm has a flexible cash policy (invests in marketable securities) – cost of borrowing to pay bills if firm has a restrictive cash policy (purposely maintains low cash balances) • MBAM614 Class 10 - 35 Target Cash Balance (flexible cash policy) Cost of holding cash Total Cost of Holding Cash Opportunity Costs Trading Costs C* • MBAM614 Size of Cash Balance, C Class 10 - 36 18 Other Factors Target cash balance is also affected by – cost of borrowing since an alternative to holding cash and marketable securities is low cash balances and borrowing – compensating balance requirements (required minimum balances) – number and complexity of checking accounts Really just additional costs to holding cash or additional adjustment costs • MBAM614 Class 10 - 37 Float The amount a firm thinks it has in its bank account and the amount the bank thinks it has frequently differ – due to both checks and deposits in process The amount a firm’s records show as its cash balance is called the Book or Ledger Balance The amount the bank claims the balance is is called the Available or Collected Balance Float = Available Balance - Book Balance • MBAM614 Class 10 - 38 19 Float Disbursement Float occurs when a firm writes cheques that don’t clear immediately – bank thinks more money is available than firm does – this is good for firm (use money they don’t really have) Collection Float happens when the firm deposits checks that aren’t cleared immediately – firm thinks it has more money than the bank thinks it does – this is not good for the firm (can’t use money they do have) Net Float • MBAM614 = Disbursement Float + Collection Float Class 10 - 39 Float Management Three parts to float: – Mail float - the time the checks (really) are in the mail – Processing float - handling time between receipt and deposit – Availability float - time to clear the banking system – both disbursements and collections are subject to these three types of delay Float management means speeding up collections (reducing collection float) and slowing disbursements (increasing disbursement float) • MBAM614 Class 10 - 40 20 Measuring Float Finding the average daily float depends on frequency of collections – for continuous collections, it is the total amount paid but uncollected on any given day – for periodic collections Average Daily = Float Check Amounts × Days Delay # Days in Period • MBAM614 Class 10 - 41 Example: Periodic Collections Suppose a $10,000 check is mailed to Priam, Inc. once every two weeks. It spends two days in the mail, a day and a half in Priam offices, and is credited to Priam’s bank account one day after it is deposited. What is the average daily float? Total delay = 2 + 1.5 + 1 = 4.5 days Over a two week period, the float is $10,000 for 4.5 days and $0 for 9.5 days so Average ($10,000 × 4.5 days + $0 × 9.5 days) Daily = 14 days Float = $3,214.29 • MBAM614 Class 10 - 42 21 Example: Continuous Collections Hector Company has $2,000 in checks arriving daily on average. Upon checking, they found that customers’ checks spend 3 days in the mail, 1 day being processed in the office, and one day before the bank credits them to Hector’s account. What is Hector’s average daily float? How much money would be freed up if they could eliminate delays? If they could reduce delays by one day? Total collection delay = 3 + 1 + 1 = 5 days On any given day, there are 5 days of payments made but uncollected or 5 × $2,000 = $10,000 = average daily float Eliminating all delays would free up the entire float ($10,000). Eliminating one day’s delay frees up $2,000. • MBAM614 Class 10 - 43 Cost of Collection Float Benefit of reducing collection delays is directly reflected in the average daily float Every dollar reduction in average daily float is a dollar freed up for use in perpetuity If a scheme to reduce collection delays is introduced, the change in average daily float - the amount freed up by the scheme - is the maximum a firm should pay for these faster collections • MBAM614 Class 10 - 44 22 Example: Faster Periodic Collection Priam’s bank has proposed a plan that will reduce their collection time by half a day. How much is the resulting reduction in collection float worth to Priam? Collection delay is reduced from 4.5 days to 4 days: Average ($10,000 × 4.0 days + $0 × 10 days) Daily = 14 days Float = $2,857.14 Since Priam’s average daily float was $3,214.29, the reduction is $3,214.29 - $2,857.14 = $357.15 Note that this is a one time saving! • MBAM614 Class 10 - 45 Example: Faster Continuous Collection How much would Hector Company save if they could reduce their collection delays from 5 days to 3 days? At 3 days, the average daily float is 3 × $,2000 = $6,000 The change in the average daily float is $10,000 - $6,000 = $4,000 Hector company saves $4,000 by reducing their collection delay • MBAM614 Class 10 - 46 23 Accelerating Collections Banks have developed a variety of services to help firms accelerate collections (for a fee, of course) Lockboxes are special post office boxes, tended by banks on behalf of their customers. – – – – firm’s customers send payments to lockbox bank opens envelopes and deposits money bank sends a summary of deposits to firm point is to reduce mail, processing, and clearing delays Electronic collection systems – debit cards used at point-of-purchase (cash must be in account) – pre-authorized payments are paperless direct transfers • MBAM614 Class 10 - 47 Cash Concentration Lockboxes and debit cards help firms get their checks cashed and deposits cleared but there are usually several accounts involved To get maximum use of their cash, firms must concentrate their cash in one account America’s largest banks offer Concentrator Accounts where deposits in all accounts in any branch across the country are automatically electronically transferred to the main account In these accounts, funds receive same day value. That is, they are available immediately (eliminates clearing delays) • MBAM614 Class 10 - 48 24 Controlling Disbursements Firms often have many bank accounts, each used for a different purpose: payments go into one, wages come from another, payables paid from yet another, etc. If balances are maintained in each account, a fair amount of cash is tied up doing nothing A Zero Balance Account is a special account with a zero balance that a firm writes checks against As checks are presented against the account, funds are automatically transferred from a concentrator account This reduces the amount of idle cash in various accounts • MBAM614 Class 10 - 49 Investing Idle Cash Given that a firm has idle cash (due to seasonal sales, planned investment, contingency reserve, etc.), the most important characteristics for short term investments are Short term to maturity to minimize interest rate risk – Low default risk (chance the issuer will default on principal or interest payments) – Highly liquid or marketable so that they can be quickly converted to cash Eg. T-Bills, Commercial Paper, Bankers Acceptances, Certificates of Deposit • MBAM614 Class 10 - 50 25 Key Points 1. Cash balances are required to pay bills and, in general, conduct business 2. Optimal cash balance is a trade-off between opportunity costs and the uncertainty of future needs 3. There are a variety of ways to manage collections but all aim at reducing the collection time thus freeing up cash for other uses 4. Money markets offer a variety of possible near-cash securities suitable for investing idle cash • MBAM614 Class 10 - 51 26