GAINESBORO MACHINE TOOLS CORPORATION
In mid September 2005, Ashley Swenson, the chief financial officer of this large CAD/CAM equipment manufacturer must decide whether to pay out dividends to the firm¡¦s shareholders or repurchase stock. If Swenson chooses to pay out dividends, she must also decide on the magnitude of the payout. A subsidiary question is whether the firm should embark on a campaign of corporate-image advertising and change its corporate name to reflect its new outlook. The case serves a review of the many practical aspects of the dividend and share buyback decisions, including(1) signaling effects, (2) clientele effects, and (3) finance and investment implications of increasing dividend payout and share repurchase decisions.
Below are listed the various issues that Gainesboro is currently facing. Issues are listed at random and in no order of importance.
Dividend Policy: Gainesboro needs to choose a adequate policy with regards to its dividend policy that does not jeopardize its ability to generate future earnings or affect its relationship with its large dividend reliant shareholder base.
Capital Structure: Debt and equity
One of the misconceptions at Gainesboro is the belief that only by paying dividends will the company be able to make a strong public gesture that the company has ¡§turned¡¨ the corner and is on track to levels of growth and profitability. Typically, growth companies do not pay dividends as earnings are usually reinvested into the company to foster growth and fund various projects and operating assets. While Gainesboro is not a standard growth company, its management and recent activity would seem to suggest that the firm is poised to become more innovative, strongly suggesting growth with new products.
The case gives three dividend alternatives for Gainesboro which are analyzed on the basis of disadvantages and advantages that would contribute to the intrinsic value of the company. These are presented below in the order that they appear in the case.
Zero ¡V dividend payout:
As mentioned in the case and by Gainesboro¡¦s management, having a zero-dividend policy would not significantly hurt the company with regards to its investor relations. In fact, due to recent technological advancements and new product issues, the company could be justified in withholding dividends from shareholders by reinvesting earnings to achieve greater growth and solidify market share. Advantages of following this alternative are as mentioned a positive cash flow, no need to borrow to pay dividends, long-term strategy that focuses on intrinsic value, and the ability to create a platform upon which Gainesboro can operate from in strength.
The disadvantages of following this approach is that it deviates away from the company¡¦s traditional past and can be viewed by investors as signs of financial trouble or inability to generate substantial returns. This can be dangerous as Gainesboro relies upon equity for the majority of financing (78%), and a mass exodus by investors could seriously hinder any growth or future prospects the company does have. 40 percent dividend payout:
A 40% dividend is almost the exact reversal of the latter alternative, where the advantages of continuing to payout high streams of cash flow could be taken as a sign of confidence by investors, thus boosting share capital. It would also serve to calm jittery investors, who would run on the slightest change in net earnings or dividend payments. The disadvantages of paying out such a high ratio are quite obvious, in that currently Gainesboro does not have the adequate capital or free cash flow on hand to pay such a large dividend to its investors. In order to make these high payments, Gainesboro would have to sacrifice certain aspects of it growth and market opportunities, and take on significant amounts of either bank loans or...
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