Corporate Governance & Dividend Policy PDF

Retention Rate (RR) = 1 - Payout Rate Firms cut dividends with Great reluctance More dividends => means less internal cash for investment Dividends are not the only way to distribute cash What is an alternative of dividends to distribute cash? Stock repurchase (buybacks) Why repurchase is getting po...

Retention Rate (RR) = 1 - Payout Rate Firms cut dividends with Great reluctance More dividends => means less internal cash for investment Dividends are not the only way to distribute cash What is an alternative of dividends to distribute cash? Stock repurchase (buybacks) Why repurchase is getting popular? Significant tax advantage and shareholders might have specific preferences What does dividend payout measure? the percentage of earnings that the company pays in dividends Payout Rate = Dividends / Net Income What is often a signal of trouble? Dividend cut Factors Affecting Dividend Policy Regarding taxes? Tax shield & dividend taxes Dividend Yield measures what? the return that an investor can make from dividends alone Dividend Yield = Dividends / Equity Value When there's a perfect market & no taxes what does it mean for the dividend policy? its irrelevant Corporate Governance definition: System of rules, practices, and processes by which a firm is directed and controlled Corporate Governance balance of interests between: 1. Shareholders 2. Management Executives 3. Customers 4. Community 10 Roles of Board of Directors 1. Select, monitor, evaluate and compensate senior management 2. Assure that management succession planning is adequate 3. Review and approve significant corporate actions 4. Review and approve the company's operating plans and budgets 5. Monitor corporate performance 6. Review the Company's financial controls 7. Review and approve the Company's financial statements 8. Review the Company's ethical standards and legal compliance 9. Oversee the Company's management of enterprise risk. 10. Monitor relations with shareholders, employees, communities What is the role of the Chairman? Presiding officer of the board Who might the Chairman also be? The CEO Who chooses the Chairman? The other board members What is one of the Chairman's responsibilities? Ensures that the firm's duties to shareholders are being fulfilled What role does the Chairman play between the board and upper management? Acts as a link What is the Chairman's role in relation to the outside world? Company's leading representative What is an independent director? A director who does not have a material or pecuniary relationship with the company. What percentage of all boards in the US are made up of independent directors? 62% What do NYSE and NASDAQ require regarding independent directors? They require more than 50% of independent directors on boards. Is there a guarantee of independent oversight from independent directors? No, there is no guarantee of independent oversight. What may CEOs do to influence independent directors? CEOs may find loopholes to influence directors. What is the purpose of the Executive Committee? A smaller group authorized to make quick decisions between the regular meetings. When does the Audit Committee typically meet? Seasonally, tied to the end of the fiscal year. What is the focus of the Governance Committee? Board recruitment and assessment. What does the Finance Committee handle? The annual budget. What is the role of the Program Committee? Long-range planning and oversight. Why Different Firms Choose Different Boards? 1. Diversified firms have larger and more independent boards 2. Firms with higher monitoring costs have larger boards 3. Firms with highly influential CEOs have boards with less independence Firm Cycle: No separation of ownership and control for small firms When a firm growth, equity of founder is not enough Separation arises naturally! However, this separation might create problems... Conflicts of Interest 1. Self-serving cash-flow diversions 2. Managerial entrenchment 3. Private benefits of control Self-serving cash-flow diversions Analyzed in detail by Jensen (1986) Payouts reduce resources under managers' control Incentives for firms to grow beyond the optimal size Growth increases managers' power! Likely in organizations with substantial FCF Issue arises from manager control of future dividend In fact, a commitment problem: managers might promise permanent increase of dividends, but might change their minds in the future… Possible Solutions: Debt Debt creation without retention of the proceeds of the issue Enables managers to effectively bond their promise to pay out future cash flow Thus, debt can be an effective substitute for dividends CEO must pay debtholder. Otherwise: firm goes bankrupt! Managerial Entrenchment Analyzed in detail by Shleifer and Vishny (1989) Managers can make manager-specific investments Consequences: 1. More costly to replace him 2. Smaller probability of replacement 3. Manager can require larger compensation in the future Causes and Consequences of Managerial Entrenchment 1. Investment in assets that have more value with current CEO, even if not value-maximizing 2. Might be an issue when managers hold little equity and shareholders are too disperse Managerial Entrenchment Strategies 1. Golden Parachutes 2. Anti-takeover devices 3. A corporate amendment in a company's charter requiring a large majority of shareholders to approve important changes “Superstar CEOs” Analyzed in detail by Malmendier and Tate (2008) Changes in behavior following prestigious awards in the business press: 1. Underperformance  2. Extract significantly more compensation 3. Spend significantly more time on public and private activities 4. More earnings management The Sarbanes–Oxley Act (SOX) Law expanding requirements for US public companies It stablishes rules regarding Boards Management Accounting Reaction to corporate and accounting scandals, such as Enron and WorldCom Major Elements 1. Establishes standards for external auditor independence 2. Senior executives take responsibility for the accuracy and completeness of corporate financial reports 3. Enhances reporting requirements for financial transactions, including off-balance-sheet transactions 4. Measures designed to help restore investor confidence in the reporting of securities analysts 5. Criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations Motivation: Prior to SOX Auditing forms were self-regulated. Performed significant non-audit or consulting work for the companies they audited Scandals showed Audit Committees who did not exercise their responsibilities or did not have the expertise to understand the complexities of the businesses Buy or sell recommendation on a stock while providing lucrative investment banking services creates at least the appearance of a conflict of interest Fund managers advocated the purchasing of technology stocks, while quietly selling them. The losses sustained also helped create a general anger among investors Stock options were not treated as compensation expense by companies, encouraging this form of compensation Cost-Benefits of SOX It is estimated that SOX costs 0.04% of firm's revenues Borrowing costs are lower for companies that improved their internal control, by between 50 and 150 basis points Lord & Benoit (2006): benefits to a compliant company in share price were greater than their SOX costs SOX Section 806 Known as the whistleblower-protection provision Prohibits any publicly traded company from retaliating against an employee for disclosing violations A federal court of appeals held that merely disclosing the identity of a whistleblower is actionable retaliation Volatility: classic measure of risk In theory, only systemic component should matter However, overall volatility might be relevant: Diversification Costs Distress Financing Risk Management Tools Hedging: Reduce firm’s exposure to fluctuations Financial Hedging Derivatives Claim on another asset Operational Hedging Using decisions to manage risk The Risk Management Process Identify important fluctuations - Risk profile of your firm/portfolio Some risks may offset each other - Consider the firm/portfolio as a whole Define risk management tools - Availability of relevant contracts - Cost of contracts - Cost of management/employee time Risk Profiles Graph of price changes relative to value changes Risk profile slope - Steeper ~ Larger exposure - Potentially more need to hedge Forward Contract What’s a forward? - Agreement to exchange an asset for a set price - Long: agree to buy the asset - Short: agree to sell the asset Advantage: customizable Disadvantage: Liquidity, default Future What’s a future? - Forwards traded on an exchange Example: CME Crude Oil Future Contract § Contract Unit: 1,000 barrels § Price Quotation: US dollars per barrel § Settlement Method: Deliverable § Delivery Procedure: at any pipeline or storage facility in Cushing, Oklahoma Example: Commodity Future Farmer expects to sell 100,000 bushels of soybeans Wants to sell at a certain price (short position) - Soybean future contracts are for 5,000 bushels - Current price is $4.50/bushel Farmer shorts 20 soybean futures - Will sell 100,000 bushels - Will receive $4.50/bushel*100,000 bushels = $450,0 Example: Commodity Future Good Harvest (>100,000 bushels) - Receive $450,000 + Extra Crop * Market Price Poor Harvest ( 0 1. Market Share 2. Supply-Chain Pricing Power 3. Economies of Scale 4. Agency Issues 5. Diversification 6. Avoid takeover attempts Valuing Synergy The incremental cashflows from M&A will be given by: Therefore, M&A can affect incremental FCs if it affects one of the following: Revenues Costs Tax Capital requirements Revenue Enhancement Ways in which M&A can affect revenues? 1. More effective advertisement 2. Stronger distribution chain 3. Market Power 4. Reduction of financial constraints, cash slack Cost Reduction Ways on which M&A can affect costs? 1. Economies of Scale 2. Supply-Chain Pricing Power Taxes Ways on which M&A can affect taxes? Unused tax credits Capital Needs Ways in which M&A can affect capital needs? Capital synergies A procedure for valuing synergy (1) the firms involved in the merger are valued independently, by discounting expected cash flows to each firm at the weighted average cost of capital for that firm. (2) the value of the combined firm, with no synergy, is obtained by adding the values obtained for each firm in the first step. (3) The effects of synergy are built into expected growth rates and cashflows, and the combined firm is re-valued with synergy. Value of Synergy = Value of the combined firm, with synergy - Value of the combined firm, without synergy Diversification: No Value Creation A takeover motivated only by diversification considerations has no effect on the combined value of the two firms involved in the takeover! The value of the combined firms will always be the sum of the values of the independent firms. Cash Slack Managers may reject profitable investment opportunities if they have to raise new capital to finance them. It may therefore make sense for a company with excess cash and no investment opportunities to take over a cash-poor firm with good investment opportunities, or vice versa. The additional value of combining these two firms lies in the present value of the projects that would not have been taken if they had stayed apart but can now be taken because of the availability of cash. Valuing Cash Slack Assume that Netscape has a severe capital rationing problem, that results in approximately $500 million of investments, with a cumulative net present value of $100 million, being rejected. IBM has far more cash than promising projects and has accumulated $4 billion in cash that it is trying to invest. It is under pressure to return the cash to the owners. If IBM takes over Netscape Inc, it can be argued that the value of the combined firm will increase by the synergy benefit of $100 million, which is the net present value of the projects possessed by the latter that can now be taken with the excess cash from the former. Tax Benefits (1) If one of the firms has tax deductions that it cannot use because it is losing money, while the other firm has income on which it pays significant taxes, the combining of the two firms can lead to tax benefits that can be shared by the two firms. The value of this synergy is the present value of the tax savings that accrue because of this merger. (2) The assets of the firm being taken over can be written up to reflect new market value, in some forms of mergers, leading to higher tax savings from depreciation in future years. Valuing Tax Benefits Assume that you are Best Buys, the electronics retailer, and that you would like to enter the hardware component of the market. You have been approached by investment bankers for Zenith, which while still a recognized brand name, is on its last legs financially. The firm has net operating losses of $ 2 billion. If your tax rate is 36%, estimate the tax benefits from this acquisition. If Best Buys had only $500 million in taxable income, how would you compute the tax benefits? If the market value of Zenith is $800 million, would you pay this tax benefit as a premium on the market value? Empirical Evidence on Synergy If synergy is perceived to exist in a takeover, the value of the combined firm should be greater than the sum of the values of the bidding and target firms, operating independently. V(AB) > V(A) + V(B) Bradley, Desai and Kim (1988) use a sample of 236 inter-firm tender offers between 1963 and 1984 and report that the combined value of the target and bidder firms increases 7.48% ($117 million in 1984 dollars), on average, on the announcement of the merger. Operational Evidence on Synergy o A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth), relative to their competitors, after takeovers. o McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for evidence on two questions - o Did the return on the amount invested in the acquisitions exceed the cost of capital? o Did the acquisitions help the parent companies outperform the competition? o They concluded that 28 of the 58 programs failed both tests! o KPMG in a more recent study of global acquisitions concludes that most mergers (>80%) fail - the merged companies do worse than their peer group. o Large number of acquisitions that are reversed within fairly short time periods. bout 20.2% of the acquisitions made between 1982 and 1986 were divested by 1988. In studies that have tracked acquisitions for longer time periods (ten years or more) the divestiture rate of acquisitions rises to almost 50%. Who gets the benefits of synergy? In theory: The sharing of the benefits of synergy among the two players will depend in large part on whether the bidding firm's contribution to the creation of the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the synergy benefits will accrue to the target firm. It is unique, the sharing of benefits will be much more equitable. In practice: Target company stockholders walk away with the bulk of the gains. Bradley, Desai and Kim (1988) conclude that the benefits of synergy accrue primarily to the target firms when there are multiple bidders involved in the takeover. They estimate that the market-adjusted stock returns around the announcement of the takeover for the successful bidder to be 2%, in single bidder, and -1.33%, in contested takeovers. Why is it so difficult to get synergy? Synergy is often used as a plug variable in acquisitions: it is the difference between the price paid and the estimated value. Even when synergy is valued, the valuations are incomplete and cursory. Some common manifestations include: Valuing just the target company for synergy (You must value the combined firm) Not thinking about the costs of delivering synergy and the timing of gains. Underestimating the difficulty of getting two organizations (with different cultures) to work together. Failure to plan for synergy. Synergy does not show up by accident. Failure to hold anyone responsible for delivering the synergy. Cash vs. Stock Cash Acquisition (A=acquirer, B=target) NPV = VB+ DV – cash cost Value of the combined firm VAB = VA + VB + DV- cash cost Stock Acquisition Value of combined firm VAB = VA + VB + DV Cost of acquisition Depends on # shares given to target stockholders Depends on post-merger stock price Cash vs. Stock Sharing gains (and risk) Target stockholders don’t participate in stock price appreciation with a cash acquisition Taxes Cash acquisitions are generally taxable Control Cash acquisitions do not dilute control Signal Stock acquisitions indicate your stock is overvalued M&A Types Friendly Work with management Hostile Toe-hold or Bear-hug Open market purchase Threaten target BOD with tender offer Proxy Fight Tender Offer Defensive Tactics Corporate charter Establishes conditions that allow for a takeover Poison pills (share rights plans) Leveraged buyouts M&A Valuation Market values Only incremental cash flows Appropriate discount rate Consider transaction costs M&A Risk Overpayment Winner’s Curse Operating Risk Integration issues, culture Mgmt resources Continued subsidization of sub-par groups Financial Risk Leverage