Gainesboro Machine Tools Corporation
Synopsis and Objectives
In mid September 2005, Ashley Swenson, the chief financial officer (CFO) of a large computer-aided design and computer-aided manufacturing (CAD/CAM) equipment manufacturer needed to decide whether to pay out dividends to the firm’s shareholders, or to repurchase stock. If Swenson chose to pay out dividends, she would have to also decide upon 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 as an omnibus review of the many practical aspects of the dividend and share buyback decisions, including (1) signaling effects, (2) clientele effects, and (3) the finance and investment implications of increasing dividend payouts and share repurchase decisions. This case can follow a treatment of the Miller-Modigliani1 dividend-irrelevance theorem and serves to highlight practical considerations to consider when setting a firm’s dividend policy. Suggested Questions for Advance Assignment to Students
The instructor could assign supplemental reading on dividend policy and share repurchases. Especially recommended are the Asquith and Mullins article2 on equity signaling, and articles by Stern Stewart on financial communication.3
In theory, to fund an increased dividend payout or a stock buyback, a firm might invest less, borrow more, or issue more stock. Which of those three elements is Gainesboro’s management willing to vary, and which elements remain fixed as a matter of the company’s policy? 2.
What happens to Gainesboro’s financing need and unused debt capacity if: a. no dividends are paid?
b. a 20% payout is pursued?
c. a 40% payout is pursued?
d. a residual payout policy is pursued?
Note that case Exhibit 8 presents an estimate of the amount of borrowing needed. Assume that maximum debt capacity is, as a matter of policy, 40% of the book value of equity. 3. How might Gainesboro’s various providers of capital, such as its stockholders and creditors, react if Gainesboro declares a dividend in 2005? What are the arguments for and against the zero payout, 40% payout, and residual payout policies? What should Ashley Swenson recommend to the board of directors with regard to a long-term dividend payout policy for Gainesboro Machine Tools Corporation? 4.
How might various providers of capital, such as stockholders and creditors, react if Gainesboro repurchased its shares? Should Gainesboro do so? 5.
Should Swenson recommend the corporate-image advertising campaign and corporate name change to the Gainesboro’s directors? Do the advertising and name change have any bearing on the dividend policy or the stock repurchase policy that you propose?
Supporting Computer Spreadsheet Files
For students: Case_25.xls
For instructors: TN_25.xls
Hypothetical Teaching Plan
What are the problems here, and what do you recommend?
The CFO needs to resolve the issue of dividend payout in order to make a recommendation to the board. She must also decide whether to embark on a stock repurchase program given a recent drop in share prices. The problems entail setting dividend policy, deciding on a stock buyback, and resolving the corporate-image advertising campaign issue. But numerical analysis of the case shows that the problem includes other factors: setting policy within a financing constraint, signaling the directors’ outlook, and generally, positioning the firm’s shares in the equity market. 2.
What are the implications of different payout levels for Gainesboro’s capital structure and unused debt capacity? The discussion here must present the financial implications of high-dividend payouts, particularly the consumption of unused debt capacity. Because of the cyclicality of demand or overruns in investment spending, some attention might be given to a sensitivity analysis cast over the...
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