Dividend Policy and Corporate Governance

Dividend Policy

• Retention Rate (RR) = 1 - Payout Rate
• Firms are reluctant to cut dividends
• Higher dividends mean less internal cash for investment.
• Dividends aren't the only way to distribute cash; stock repurchases are an alternative.
• Stock repurchases are popular due to tax advantages and shareholder preferences.
• Dividend payout measures the percentage of earnings paid out as dividends.
• Payout Rate = Dividends / Net Income
• A dividend cut is often a signal of trouble.
• Tax shield and dividend taxes affect dividend policy.
• Dividend Yield = Dividends / Equity Value; measures the return from dividends alone.
• In a perfect market with no taxes, dividend policy is irrelevant.

Corporate Governance

• Corporate Governance is a system of rules, practices, and processes to direct and control a firm.
• Corporate Governance balances the interests of shareholders, management, customers, and the community.
• Board of Directors have 10 key roles:
  • Selecting, monitoring, evaluating, and compensating senior management.
  • Ensuring adequate management succession planning.
  • Reviewing and approving significant corporate actions.
  • Reviewing and approving operating plans and budgets.
  • Monitoring corporate performance.
  • Reviewing financial controls.
  • Reviewing and approving financial statements.
  • Reviewing ethical standards and legal compliance.
  • Overseeing enterprise risk management.
  • Monitoring shareholder, employee, and community relations.
• The Chairman is the presiding officer of the board, and might be the CEO.
• Other board members choose the Chairman.
• The Chairman ensures the firm fulfills its duties to shareholders and acts as a link between the board and upper management, and represents the company externally.
• Independent directors have no material or pecuniary relationship with the company.
• 62% of US boards are composed of independent directors.
• NYSE and NASDAQ mandate over 50% independent directors.
• Independent oversight is not guaranteed.
• CEOs may influence independent directors.
• The Executive Committee facilitates quick decisions between regular meetings.
• The Audit Committee meets seasonally, often at the end of the fiscal year.
• The Governance Committee focuses on board recruitment and assessment.
• The Finance Committee manages the annual budget.
• The Program Committee oversees long-range planning.

Conflicts of Interest & Managerial Entrenchment

• Conflicts of interest can arise from self-serving cash flow diversions and managerial entrenchment.
• Private benefits of control can stem from managerial decisions benefitting managers at the expense of other stakeholders.
• Jensen (1986) analyzed these issues.
• Payouts reduce resources under managers' control.
• Firms may grow beyond optimal size due to manager incentives.
• Growth increases managerial power, potentially in firms with substantial free cash flow (FCF).
• A commitment problem arises from managers promising permanent dividend increases but potentially changing their minds.
• Debt can be a substitute for dividends to bond payment promises, as CEOs must pay debt holders to avoid bankruptcy.
• Shleifer and Vishny (1989) analyzed managerial entrenchment.
• Managers might make manager-specific investments, making replacements more costly and less likely.
• Higher future compensation may be demanded by entrenched managers.
• Entrenchment can involve investments in assets that have more value with the current CEO, even if not value-maximizing.
• This is an issue when managers hold little equity and shareholders are dispersed.
• Golden parachutes, anti-takeover devices, are managerial entrenchment strategies.

SOX Act & Corporate Scandals

• The Sarbanes-Oxley Act (SOX) expanded requirements for US public companies.
• SOX addresses boards, management, and accounting following corporate scandals like Enron and WorldCom.
• Core elements: external auditor independence, senior executive responsibility for financial reports, and enhanced reporting, including off-balance sheet transactions.
• It establishes criminal penalties for tampering with financial records or investigations.
• Prior to SOX, auditing forms were largely self-regulated.
• SOX is estimated to cost 0.04% of a firm's revenues.
• SOX can reduce borrowing costs (50-150 bps).
• SOX section 806 protects whistleblowers from retaliation.

Risk Management

• Volatility is a classic risk measure.
• Diversification costs, distress, and financing can be affected by overall volatility.
• Risk management tools include hedging (reducing exposure to fluctuations).
• Financial hedging uses derivatives (claims on other assets).
• Operational hedging uses decisions to manage risk.
• The risk management process includes identifying fluctuations, assessing a firm's/portfolio's risk profile, defining tools, considering availability and cost, and accounting for employee time.
• Risk profiles are graphed showing price changes relative to value changes. Steeper slopes mean higher exposure and potential need for hedging.
• Forward contracts are agreements to exchange an asset for a set price (long = buy, short= sell). They are customizable but can have liquidity and default issues.
• Futures contracts are standardized forward contracts traded on exchanges (e.g., CME crude oil futures).

Mergers and Acquisitions

• Mergers and acquisitions (M&A) can affect incremental free cash flows (FCF) by influencing revenues, costs, taxes, and capital requirements.
• Revenue enhancement can come from improved advertising, stronger distribution, market power, and reduced financial constraints.
• Cost reduction from M&A includes economies of scale and supply chain pricing power.
• Tax benefits arise from unused tax credits and income tax savings from mergers.
• Capital needs can be impacted by capital synergies.
• Synergy is the incremental value from a merger, calculated as the difference between the combined firm's value with and without synergy.
• Diversification does not inherently create value.
• Cash slack can create value in a merger, as the cash-rich firm can finance projects in the cash-poor target firm.
• Tax benefits can stem from using net operating losses (NOLs) from one firm in a merger for tax savings with the other.
• Synergy is often a "plug" variable, valued with incomplete, cursory valuations.
• Common errors involve valuing only the target company, ignoring delivery costs, underestimating organizational integration.
• Acquisition methods: cash or stock offers.
• Cash vs stock acquisitions differ in gain sharing among shareholders and tax implications.
• Cash acquisitions don't dilute control or reflect overvalued stock.
• A hostile takeover involves strategies like toe-holds, bear hugs, open-market purchases, and proxy fights, possibly leading to tender offers.
• Defensive tactics may include corporate charters, poison pills, and leveraged buyouts.
• M&A risks include overpayment to the target, integration issues, managerial resource concerns, and continued subsidization of sub-optimal groups.
• Empirical evidence shows mixed success, in some cases M&A leads to a significant increase in value, but most fail to create value for shareholders.