Tyler Cowen asks some rather interesting questions concerning Microsoft’s decision to declare a $3 per share “special dividend” (since Microsoft has more than 10 billion shares outstanding, this translates into more than $32 billion in cash, thus representing the largest corporate dividend payment in history). Specifically, 1) would these dividends have happened without the Bush tax cuts, and 2) does Microsoft fear that Kerry will win and raise taxes on dividends? Professor Cowen’s answers to these questions are “maybe not” and “probably” respectively. The Wall Street Journal corroborates Professor Cowen by noting that “…the company was clearly concerned with the possibility that John Kerry might be elected President and carry out his promise to return dividends to their former status as ordinary income (thus raising the dividend tax back to the nearly 40% Clinton-era top rate from today’s 15%).

That dividend policy is sensitive to tax rules is empirically borne out by a new working paper authored by Raj Chetty and Emmanuel Saez entitled “Do Dividend Payments Respond to Taxes? Preliminary Evidence from the 2003 Dividend Tax Cut“. Chetty and Saez note “The individual income tax burden on dividends was lowered sharply in 2003 from a maximum rate of 35% to 15%, creating a unique opportunity to analyze the effects of dividend taxes on dividend payments by U.S. corporations.” They find, among other things, that 1) the fraction of publicly traded firms paying dividends began to increase in 2003 after having declined continuously for more than two decades, and 2) firms that were already paying dividends prior to 2003 raised their dividend payments significantly after the tax cut became law.

A long standing theorem in finance is that any time a firm’s shareholders can find more highly valued uses of capital than the firm, then excess cash should be returned to shareholders. Indeed, the Washington Post quotes Wharton finance professor Jeremy Siegel as saying that “Cash that’s just sitting around gets discounted”. However, this theorem implicitly assumes that there are no tax asymmetries. The most famous tax asymmetry in corporate finance is that debt related income is only taxed at the personal level, whereas equity related income is taxed at both the corporate and personal levels. At the margin, this tax asymmetry compels firms to be more highly leveraged than they otherwise might be, and also causes firms to avoid generating cash distributions for their shareholders. Another important tax asymmetry which existed until last year was that cash distributions through share buybacks were more tax-efficient transactions than cash distributions through dividend payments. While the 2003 dividend tax reform doesn’t address the double taxation issue, it does significantly reduce the tax penalty for cash distributions to shareholders. Furthermore, the tax code is now neutral about the form of equity-related cash distributions, whereas before it favored share buybacks over dividend payments.

Lately, there have been a slew of articles concerning the impact of high fuel prices on airline profitability. A common statistic which is being bandied about in the news media is that for every $1 increase in fuel costs, airline industry costs increase by $425 million. Indeed, it has become fashionable lately for airline executives to not only blame high fuel prices for their lack of profitability, but also to argue for the “need” for government intervention. As a case in point, consider the following quotes (taken from a June 3, 2004 Washington Post article entitled “Airlines Find Fuel Prices Tough to Swallow”):

1. “‘The price of oil has taken our profitability hopes away from us,” said Gordon M. Bethune, Continental Airlines Inc.’s chairman and chief executive. “The government ought to recognize that this is pretty serious.'”

2. “United Airlines blamed high fuel costs for its operating loss in April. If prices had been lower, the airline would have reported a profit during the month, said Jake Brace, chief financial officer of UAL Corp., which owns United Airlines.”

After reading quotes such as these, one would think that the airline industry is powerless to do anything about fuel prices, and that the government may be their only “hope”. Of course, this is complete nonsense. Firms are in the business of taking and managing risk; after all, this is how they earn profit. Corporate risk management theory makes a compelling case for the notion that firms should hedge or insure “incidental” risks (which are risks that they cannot control, such as commodity prices), and retain “core” risks (which are risks that they are in a position to favorably influence). In the case of the airline industry, the price of jet fuel is clearly an “incidental” risk and therefore it represents the type of risk which ought to be transferred. On the other hand, passenger safety and security represent examples of “core” risks which the firm presumably has a comparative advantage in managing.

In light of these considerations, it is interesting to look under the hood at actual airline industry hedging practices. Casual empiricism reveals that the propensity to hedge tends to be positively related to profitability and inversely related to the risk of default. In other words, the more profitable, less financially troubled airlines (e.g., companies such as Southwest Airlines, Air Tran and Jet Blue) tend to aggressively hedge jet fuel prices, whereas the less profitable, more financially troubled airlines (e.g., Continental, Delta, Northwest, American and United) either do limited hedging or none whatsoever. Southwest Airlines is 80 percent hedged for the remainder of 2004 with prices capped below $24 per barrel, 80 percent hedged for 2005 with prices capped at $25 per barrel and 45 percent hedged for 2006 with prices capped at $28 per barrel. Compare Southwest’s policy with the policies followed by Northwest Airlines (only 7% of its 2004 fuel needs are hedged at $37 per barrel and none of its 2005 fuel needs), American Airlines (no hedging), and United Airlines (no hedging). During the second quarter of 2004, Southwest Airlines’ net income for the second quarter of 2004 was $113 million, $90 million of which was attributable to the lower jet fuel prices afforded by their hedging program. In contrast, American and United are expected to pay $700 million and $750 million respectively in additional fuel costs during 2004.

These data beg an obvious question; specifically why is there such a glaring disparity in terms of the risk management strategies of these companies? Digging a bit deeper, it is important to note the risk bearing incentive effects related to corporate limited liability, and how this affects corporate investment decision making. Finance theory suggests that when firms are financially distressed (as is the case with many airline companies), limited liability gives rise to various moral hazard problems. Among other things, firms that are close to going bankrupt often fall prey to perverse risk bearing and investment incentives; specifically, they tend to underinvest as well as take on too much risk. Since limited liability creates an asymmetry in terms of the impact of risk bearing on shareholders; i.e., shareholders are shielded from downside risk and exposed to upside risk, this will often compel financially distressed firms to adopt risk management strategies which wouldn’t be considered by financially sound firms. Basically, if you find yourself up against the wall, you may prefer not to hedge risk. If you lose, your losses are limited, but if you win, your gains are unlimited. The prospect of a government bailout further exacerbates this moral hazard and makes it even less likely that a financially troubled airline will be inclined to hedge.

In the case of the airline industry, the unprofitable and financially troubled firms consequently have greater incentive to take on incidental risks than profitable companies. Fuel price risk is clearly symmetric; while an increase in price reduces profitability, a price decrease enhances profitability. By rolling the dice and remaining largely unhedged, companies like Northwest, American, and United will benefit if fuel prices fall (indeed, as investments these companies’ stocks basically represent highly speculative, leveraged plays on future fuel prices). However, if prices rise, these companies have other risk management mechanisms at their disposal; specifically, bankruptcy protection and the possibility of government loan guarantees. Since these companies do not have to put much of their own money at risk, the costs of hedging likely outweigh the benefits. The reverse is true for profitable companies that are not likely to go bankrupt (such as Southwest Airlines). For these companies, the “option to default” is deeply out of the money, as is the prospect of a government bailout. Since their own money is at risk, they are more likely to adopt prudent business practices (including hedging incidental risks)

In closing, I would like to point out that there have been some academic studies done on this very topic; I would point the reader to a working paper by David Carter, Daniel Rogers and Betty Simkins entitled “Does Fuel Hedging Make Economic Sense? The Case of the U.S. Airline Industry“. These same authors have also recently written an interesting case study of Southwest Airlines entitled “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines“.