Gainesboro Machine Tools Corporation Essay

Synopsis and ObjectivesIn mid September 2005, Ashley Swenson, the chief fiscal police officer (CFO) of a large computer-aided design and computer-aided manufacturing ( wiener/CAM) equipment manufacturer needed to decide whether to devote divulge divid block ups to the pie-eyedlys sh atomic number 18holders, or to acquire venture teleph cardinal line. If Swenson chose to kick in divulge dividends, she would af warm to excessively decide upon the magnitude of the payout. A subsidiary suspicion is whether the firm should pretend on a campaign of merged-image publicise, and variegate its merged name to reflect its advanced outlook. The cheek serves as an omnibus revaluation of the m any practical aspects of the dividend and partake in buyback finiss, including (1) polarity effects, (2) clientele effects, and (3) the finance and set upment implications of increasing dividend payouts and shargon repurchase finales. This miscue can fit a treatment of the Miller- Modigliani1 dividend-irrelevance theorem and serves to eminentlight practical con alignrations to consider when linguistic context a firms dividend form _or_ system of g everyplacenment. Suggested Questions for Advance Assignment to StudentsThe instructor could assign subsidiary reading on dividend indemnity and sh ar repurchases. Especially adviseed ar the Asquith and Mullins article2 on lawfulness signaling, and articles by Stern Stewart on fiscal communication.31.In theory, to fund an increase dividend payout or a song buyback, a firm competency invest slight, borrow more, or issue more stock. Which of those three elements is Gainesboros counselling provideing to vary, and which elements remain fixed as a matter of the caller-outs insurance insurance? 2.What happens to Gainesboros financing need and unuse debt cleverness if a. no dividends atomic number 18 paid?b. a 20% payout is pursued?c. a 40% payout is pursued?d. a residual payout policy is pursued? row o f business that oddball let out 8 presents an consider of the amount of borrowing needed. break that utmost debt capacity is, as a matter of policy, 40% of the obligate value of loveliness. 3. How might Gainesboros various providers of working hood, such as its stockholders and creditors, play off if Gainesboro declares a dividend in 2005? What are the arguments for and a buildst the adjust payout, 40% payout, and residual payout policies? What should Ashley Swenson inspire to the come along of directors with regard to a long-term dividend payout policy for Gainesboro Machine Tools association?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 publicise campaign and corporate name diverge to the Gainesboros directors? Do the advertising and name change adopt any pram on the dividend policy or the stock repurchase policy that you offer up?Supporting Computer Spreadsheet FilesFor students matter_25.xlsFor instructors TN_25.xlsHypothetical T all(prenominal)ing Plan1.What are the problems here, and what do you recommend?The CFO call for to resolve the issue of dividend payout in put together to drag a recommendation to the carte du jour. She must(prenominal) also decide whether to embark on a stock repurchase program given a recent drop in share expenditures. The problems entail setting dividend policy, deciding on a stock buyback, and resolving the corporate-image advertising campaign issue. exclusively numerical analysis of the case shows that the problem includes other elements setting policy within a financing constraint, signaling the directors outlook, and ecumenically, positioning the firms shares in the equity merchandise. 2.What are the implications of different payout trains for Gainesboros capital organize and unused debt capacity? The intervention here must present the monetary im plications of high-dividend payouts, particularly the consumption of unused debt capacity.Because of the cyclicality of demand or overruns in coronation spending, some attention might be given to a sensitivity analysis cast over the entire 2005 to 2011 period. 3.What is the constitution of the dividend conclusion that Swenson must make? What are the pros and cons of the alternative positions? (Or alternatively, Why pay any dividends?) How depart Gainesboros various providers of capital, such as its stockholders and bankers, react to a resoluteness of no dividend? What intimately(predicate) the announcement of a 40% payout? How would they react to a residual payout? The instructor needs to elicit from the students the nonions that the dividend-payout announcement whitethorn advert stock outlay and that at least some stockholders prefer dividends. Students should also mention the signaling and clientele considerations.4.What risks does the firm face?Discussion hobby this p erplexity should address the nature of the industry, the strategy of the firm, and the firms surgical operation. This discussion go forth lay the groundwork for the review of strategic considerations that bears on the dividend decision. 5.What is the nature of the share repurchase decision that Swenson must make? How would this affect the dividend decision? The discussion here must present the repercussions of a share repurchase decision on the share price, as well as on the dividend question. Signaling and clientele considerations must also be considered.6.Does the stock foodstuff appear to reward high-dividend payout? What just about low-toned-dividend payout? Does it matter what type of investor owns the shares? What is the involve on share price of dividend policy? The data can be see to support both view. The point is to show that simple extrapolations from stock grocery store data are untrustworthy, more often than not because of econometric problems associated with size and omitted variables (see the Black and Scholes article).4 7.What should Swenson recommend?Students must synthesize a course of action from the many facts and considerations raised. The instructor may choose to scram the discussion by using an organizing example such as FRICTO (flexibility, risk, income, control, timing, and other) on the dividend and share repurchase issues. The image advertising and name change issue result be recognized as anothermanifestation of the firms positioning in the capital foodstuffs, and the need to give effective signals.The kinfolk discussion can end with the students voting on the alternatives, followed by a summary of key points. troops TN1 and TN2 suss out two short technical notes on dividend policy, which the instructor may either use as the foundation for closing comments or distri preciselye presently to the students after the case discussion.Case AnalysisGainesboros plus needsThe companys investing spending and financing requi rements are fructifyd by ambitious captureth goals (a 15% annual target is discussed in the case), which are to be achieved by a repositioning of the firm by from its traditional tools-and-molds business and beyond its CAD/CAM business into a new line of products integrating hardware and softwareto provide complete manufacturing systems. CAD/CAM commanded 45% of measure gross revenue ($340.5 million) in 2004 and is judge to grow to three-quarters of gross sales ($1,509.5 million) by 2011, which implies a 24% annual rate of evolution in this business segment over the subsequent seven years.In addition, planetary sales are expected to grow by 37% intensify over the subsequent seven years.5 By contrast, the presses-and-molds segment will grow at about 2.7% annually in nominal terms, which implies a prejudicial real rate of growth in what constitutes the bulk of Gainesboros real business.6 In short, the companys asset needs are compulsive primarily by a shift in the companys strategic focus. Financial implications of payout alternativesThe instructor can guide the students through the monetary implications of various dividend-payout levels either in abbreviated form (for one class period) or in detail (for two classes). The abbreviated cuddle shot uses the total change cling figures (that is, for 20052011) found in the right-hand column of case exhibit 8. In essence, the approach uses the basic sources-and-uses of funds identity summation change = New debt + (Profits Dividends)With asset additions fixed largely by the firms combative strategy, and with profits determined largely by the firms operating strategy and the environment, the remaining large-decision variables are changes in debt and dividend payout. rase additions to debt are constrained, however, by the firms maximum supplement target, a debt/equity ratio of 0.40. This framework can be spelled out for the students to dish out them envision the monetary context. deliver TN3 presen ts an analysis of the effect of payout on unused debt capacity based on the projection in case Exhibit 8. The top panel summarizes the firms investment program over the herald period, as well as the financing provided by natural sources. The bottom panel summarizes the effect of high payouts on the firms financing and unused debt capacity. The principal insight this analysis yields is that the firms unused debt capacity disappears rapidly, and maximum leverage is achieved as the payout increases. Going from a 20% to a 40% dividend payout (an increase in cash flow to shareholders of $95.6 million),7 the company consumes $134 million in unused debt capacity.Evidently, a multiplier kindred exists in the midst of payout and unused debt capacityevery dollar of dividends paid consumes about $1.408 of debt capacity. The multiplier exists because a dollar must be borrowed to replace each dollar of equity paid out in dividends, and each dollar of equity lost sacrifices $0.40 of debt capacity that it would have otherwise carried.Whereas the abbreviated approach to analyzing the implications of various dividend-payout levels considers total 2005 to 2011 cash flows, the detailed approach considers the pattern of the soul annual cash flows. Exhibit TN4 reveals that, although the debt/equity ratio associated with the 40% payout policy is well under the maximum of 40 in 2011, the maximum is bruiseed in the preceding years. The graph suggests that a payout policy of 30% is about the maximum that does not breach the debt/equity maximum.Exhibits TN5 and TN6 reveal some of the financial reportage and valuation implications of alternative dividend policies. Those faces use a simple dividend valuation approach and assume a terminal value estimated as a triple of fee. The analysis is unscientific, as the case does not contain the information with which to estimate a discount rate based on the capital asset pricing model (CAPM).9 The discounted cash flow (DCF) values sh ow that the differences in firm values are not that large and that the dividend policy filling in this case has little effect on value. This expiration is legitimate with the Miller-Modigliani dividend-irrelevance theorem.Regarding the financial-reporting effects of the policy choices, one sees that earnings per share (EPS on line 30 in Exhibits TN5 and TN6) and the implied stock price (line 31) grow more tardily at a 40% payout policy, because of the greater interest expense associated with higher(prenominal) leverage (see the cumulative source on line 22). Return on average equity (unused debt capacity on line 28) rises with higher leverage, however, as the equity base contracts. The instructor could use insights such as those to stimulate a discussion of the signaling consequences of the alternative policies, and whether investors even care about performance measures, such as EPS and return on equity (ROE).10 pretend assessmentNeither the abbreviated nor detailed forecasts co nsider adverse deviations from the plan. Case Exhibit 8 assumes no cyclical downturn over the seven-year forecast period. Moreover, the model assumes that net margin doubles to 5% and past increases to 8%. The company may be able to rationalize those optimistic assumptions on the basis of its restructuring and the growth of the stylised Workforce, notwithstanding such a veridical discontinuity in the firms performance will warrant elaborated scrutiny. Moreover, continued growth may require new product information after 2006, which may incur significant research-and-development (R&D) expenses and reduce net margin.Students will point out that, so far-off, the companys restructuring strategy is associated with losings (in 2002 and 2004) or else than gains. Although restructuring appears to have been necessary, the credibility of the forecasts depends on the assessment of counsels ability to begin harvesting potential profits. Plainly, the Artificial Workforce has the competit ive advantage at the moment, but the volatility of the firms performance in the ongoing period is significant The ratio of the be of goods interchange to sales rose from 61.5% in 2003 to 65.9% in 2004.Meanwhile, the ratio of selling, general, and administrative expenses to sales is projected to fall from 30.5% in 2004 to 24.3% in 2005. Admittedly, the restructuring accounts for some of this volatility, but the case suggests several sources of volatility that are external to the company economic recession, currency, new-competitor market entry, new product mishaps, live overruns, and unexpected acquisition opportunities.A picture survey of risks invites students to perform a sensitivity analysis of the firms debt/equity ratio under a reasonable downside scenario. Students should be encourage to exercise the associated computer spreadsheet model, making modifications as they see fit. Exhibit TN7 presents a forecast of financial results, assuming a net margin that is smaller tha n the preceding forecasts by 1% and sales growth at 12% rather than 15%.This exhibit also illust pass judgment the implications of a residual dividend policy, which is to recount the compensation of a dividend only if the firm can afford it and if the payment will not cause the firm to violate its maximum debt ratios. The exhibit reveals that, in this adverse scenario, although a dividend payment would be made in 2005, none would be made in the two years that follow. Thereafter, the dividend payout would rise. The general insight remains that Gainesboros unused debt capacity is relatively slender and easily exhausted.The stock-buyback decisionThe decision on whether to buy back stock should be that, if the intrinsic value of Gainesboro is greater than its current share price, the shares should be repurchased. The case does not provide the information needed to make shift cash flow projections, but one can work rough the problem bymaking some assumptions. The DCF calculation pre sented in Exhibit TN8 uses net income as a proxy for operating income,11 and assumes a weighted-average cost of capital (WACC) of 10%, and a terminal value growth factor of 3.5%. The equity value per share comes out to $35.22, representing a 59% bounteousness over the current share price. Based on that calculation, Gainesboro should repurchase its shares.Doing so, however, will not resolve Gainesboros dividend/financing problem. Buying back shares would advance reduce the resources available for a dividend payout. Also, a stock buyback may be inconsistent with the message that Gainesboro is trying to convey, which is that it is a growth company. In a perfectly efficient market, it should not matter how investors got their money back (for example, through dividends or share repurchases), but in inefficient markets, the portion of dividends and buybacks as signaling mechanisms cannot be disregarded. In Gainesboros case, we seem to have the case of an inefficient market the case sug gests that information asymmetries exist betwixt company insiders and the stock market.Clientele and signaling considerationsThe profile of Gainesboros equity owners may influence the choice of dividend policy. Stephen Gaines, the board chair and scion of the founders families and management (who conjointly own about 30% of the stock), seeks to maximize growth in the market value of the companys stock over time. This goal invites students to take apart the usurpation of the dividend policy on valuation. Nevertheless, some students might point out that, as Gaines and Scarboros population of diverse and disinterested heirs grows, the demand for current income might rise. This naturally raises the question Who owns the firm? The stockholder data in case Exhibit 4 show a marked fumble over the past 10 years, moving a course from long-term soul investors and toward short-term traders and away from growth-oriented institutional investors and toward value investors.At least a quarter of the firms shares are in the hands of investors who are looking for a turnaround in the not too contrary future.12 This lends urgency to the dividend and signaling question. The case indicates that the board committed itself to resuming adividend as early as possible ideally in the year 2005. The boards letter charges this dividend decision with some heavy signaling implications because the board previously stated a desire to pay dividends, if it now declares no dividend, investors are bound to interpret the declaration as an indication of adversity. 1 is reminded of the story, Silver Blaze, written by Sir Arthur Conan Doyle featuring the famous protagonist Sherlock Holmes, in which Dr. Watson asks where to look for a clueTo the curious incident of the dog in the nighttime, says Holmes. The dog did nothing in the nighttime, Watson answers.That was the curious incident, remarked Sherlock Holmes.13A mishap to signal a recovery might have an adverse impact on share price. In this context, a dividendalmost any dividendmight indicate to investors that the firm is prospering more or less harmonize to plan.Astute students will observe that a subtler signaling problem occurs in the case What kind of firm does Gainesboro want to signal that it is? Case Exhibit 6 shows that CAD/CAM equipment and software companies pay low or no dividends, in contrast to electrical machinery manufacturers, who pay out one-quarter to as a good deal as half of their earnings. One can argue that, as a result of its restructuring, Gainesboro is making a pitch contour from the latter to the former. If so, the issue then becomes how to tell investors.The article by Asquith and Mullins14 suggests that the most credible signal about corporate prospects is cash, in the form of either dividends or capital gains. Until the Artificial Workforce product line begins to deliver significant flows of cash, the share price is not likely to respond significantly. In addition, any decline in cash flo w, caused by the risks listed earlier, would worsen the anticipated gain in share price. By implication, the AsquithMullins work would cast doubt on corporate-image advertising. If cash dividends are what matters, then spending on advertising and a name change might be wasted.Stock prices and dividendsSome of the advocates of the high-dividend payout suggest that high stock prices are associated with high payouts. Students may attempt to prove that point by abstracting from the evidence in case Exhibits 6 and 7. As we know from academician research (for example, Friend and Puckett),15 proving the relationship of stock prices to dividend payouts in a scientific way is extremely difficult. In simpler terms, the reason is because the price/earnings (P/E) ratios are probably associated with many factors that may be represented by dividend payout in a regression model. The most important of those factors is the firms investment strategy Miller and Modiglianis16 dividend-irrelevance theo rem makes the point that the firms investmentsnot the dividends it paysdetermine the stock prices.One can just as easily pull in evidence of this assertion from case Exhibit 7. The sample of zero-payout companies has a higher average expected return on capital (24.9%) than the sample of high-payout companies (average expected return of 9.4%) one may conclude that zero-payout companies have higher returns than the high-payout companies and that investors would rather reinvest in zero-payout companies than receive a cash payout and be forced to redeploy the capital to lower-yielding investments.DecisionThe decision for students is whether Gainesboro should buy back stock or declare a dividend in the third quarter (although, for practical purposes, students will find themselves deciding for all of 2005). As the analysis so far suggests, the case draws students into a tug-of-war between financial considerations, which tend to reject dividends and buybacks at least in the near term, and signaling considerations, which call for the resumption of dividends at some level, however, small. Students will tend to cluster around the three proposed policies (1) zero payout, (2) low payout (1% to 10%), and (3) a residual payout scheme calling for dividends when cash is available.The arguments in favor of zero payout are (1) the firm is making thetransition into the CAD/CAM industry, where zero payout is the mode (2) the company should not force out the financial statements and act like a blue-chip firmGainesboros risks are large enough without compounding them by disgorging cash and (3) the signaling legal injury already occurred when the directors suspended the dividend in 2005.The arguments in favor of a low payout are usually based on optimism about the firms prospects and on beliefs that Gainesboro has sufficient debt capacity, that Gainesboro is not exactly a CAD/CAM firm, and that any dividend that does not restrict growth will enhance share prices. Usually, the sig naling argument is most significant for the proponents of this policy. The residual policy is a convenient alternative, although it resolves none of the thorny policy issues in the case. A residual dividend policy is bound to create significant signaling problems as the firms dividend waxes and wanes through each economic cycle.The question of the image advertising and corporate name change will entice the naive student as a relatively cheap solution to the signaling problem. The instructor should altercate such thinking. Signaling research suggests that effective signals are both transparent and costly. The advertising and name change, costly as they may be, hardly trammel as unambiguous. On the other hand, seasoned investor relations professionals believe that advertising and name changes can be effective in alerting the capital markets to major corporate changes when integrated with other signaling de ungodlinesss such as dividends, capital structure, and investment announceme nts. The whole point of such campaigns should be to gain the attention of the lead steer opinion leaders.Overall, inexperienced students tend to fling the signaling considerations in this case quite readily. On the other hand, senior(a) executives and seasoned financial executives view signaling quite seriously. If the class votes to buy back stock or to declare no dividend in 2005, intercommunicate some of the students to dictate a letter to shareholders explaining the boards decision may be useful. The difficult issues of credibility will emerge in class with a critique of this letter.If the class does vote to declare a dividend payout, the instructor can challenge the students to identify the operating policies they gambled on to make their decision. The underlying question If adversity strikes, what will the class sacrifice outset debt, or dividend policies?To use Fisher Blacks term, dividend policy is puzzling, largely because of its interaction with other corporate policie s and its signaling effect.17 Decisions about the firms dividend policy may be the best way to illustrate the richness of managers judgments in corporate finance. However the class votes, one of the teaching points is that managers are paid to make difficult, even high-stakes policy choices on the basis of half(prenominal) information and uncertain prospects. Exhibit TN1GAINESBORO MACHINE TOOLS CORPORATIONThe Dividend Decision and support PolicyThe dividend decision is necessarily part of the financing policy of the firm. The dividend payout chosen may affect the creditworthiness of the firm and hence the costs of debt and equity if the cost of capital changes, so may the value of the firm. Unfortunately, one cannot determine whether the change in value will be positive or prejudicious without knowing more about the optimality of the firms debt policy. The link between debt and dividend policies has received little attention in academic circles, largely because of its complexit y, but it remains an important issue for chief financial officers and their advisors. The Gainesboro case illustrates the impact of dividend payout on creditworthiness.Dividend payout has an unusual multiplier effect on financial reserves. prorogue TN1 varies the total 20052011 sources-and-uses of funds information given in case Exhibit 8, according to different dividend-payout levels. Exhibit TN1 (continued) send back TN1Exhibit TN1 (continued)As Table TN1 reveals, one dollar of dividends paid consumes $1.40 in unused debt capacity. At maiden glance, this result seems surprisingunder the sources-and-uses framework, one dollar of dividend is financed with only one dollar of borrowing. The sources-and-uses reasoning, however, ignores the erosion in the equity base A dollar paid out of equity also eliminates $0.40 of debt that the dollar could have carried. Thus, a multiplier effect exists between dividends and unused debt capacity, whenever a firm borrows to pay dividends.Choosing a dividend payout will affect the probability that the firm will breach its maximum target leverage. Figure TN1 traces the debt/equity ratios associated with Gainesboros dividend-payout ratios.Figure TN1.Plainly, the 40% dividend-payout ratio violates Gainesboros maximum debt/equity ratio of 40%.The conclusion is that, because the dividend policy affects the firms creditworthiness, senior managers should weigh the financial side effects of their payout decisions, along with the signaling, segmentation, and investment effects, to arrive at their final decision for the dividend policy. Exhibit TN2GAINESBORO MACHINE TOOLS CORPORATIONSetting Debt and Dividend-Payout TargetsThe Gainesboro Machine Tools Corporation case well illustrates the challenge of setting the two most obvious components of financial policy target payout and debt capitalization. The policies are linked with the firms growth target, as shown in the self-sustainable growth modelgss = (P/S S/A A/E)(1 DPO)Wheregss is the self-sustainable growth rateP is net incomeS is salesA is assetsE is equityDPO is the dividend-payout ratioThis model describes the rate at which a firm can grow if it issues no new shares of common land stock, which describes the behavior or circumstances of virtually all firms. The model illustrates that the financial policies of a firm are a closed system emersion rate, dividend payout, and debt targets are interdependent. The model offers the key insight that no financial policy can be set without reference to the others. As Gainesboro shows, a high dividend payout affects the firms ability to achieve growth and capitalization targets and vice versa. Myopic policyfailing to manage the link among the financial targetswill result in the failure to meet financial targets.Setting Debt-Capitalization Targetsfinance theory is split on whether gains are created by optimizing the mix of debt and equity of the firm. Practitioners and many academicians, however, believe that debt op tima exist and devote great effort to choosing the firms debt-capitalization targets. Several classic competing considerations influence the choice of debt targets1.Exploit debt-tax shields. Modigliani and Millers theorem implies that in the world of taxes, debt financing creates value.1 Later, Miller theorized that when personal taxes are accounted for, the leverage choices of the firm might not create value. So far, the bulk of the semiempirical evidence suggests that leverage choices do affect value. 2.Reduce costs of financial affliction and bankruptcy. Modigliani and Millers theory naively implied that firmsshould lever up to 99% of capital. Virtually no firms do this. Beyond some prudent level of debt, the cost of capital becomes very high because investors recognize that the firm has a greater probability of suffering financial distress and bankruptcy. The critical question then becomes What is prudent? In practice, two classic benchmarks are used a. Industry-average debt/c apital Many firms lever to the degree practiced by peers, but this policy is not very sensible. Industry averages ignore differences in chronicle policies, strategies, and earnings outlooks. Ideally, prudence is defined in firm-specific terms.In addition, capitalization ratios ignore the crucial fact that a firm goes bankrupt because it runs out of cash, not because it has a high debt/capital ratio. b. Firm-specific debt service More firms are setting debt targets based on the forecasted ability to cover principal and interest payments with earnings before interest and taxes (EBIT). This practice requires forecasting the annual probability dissemination of EBIT and setting the debt-capitalization level, so that the probability of covering debt service is consistent with managements strategy and risk tolerance. 3.Maintain a reserve against unforeseen adversities or opportunities. Many firms keep their cash balances and lines of unused bank credit large than may seem necessary, bec ause managers want to be able to respond to abrupt demands on the firms financial resources caused, for example, by a price war, a large product recall, or an opportunity to buy the toughest competitor.Academicians have no scientific advice about how large those reserves should be. 4.Maintain future price of admission to capital. In difficult economic times, less creditworthy borrowers may be shut out from the capital markets and, thus, unable to obtain funds. In the joined States, less creditworthy refers to the companies whose debt ratings are less than investment grade (which is to say, less than BBB2 or Baa3). Accordingly, many firms set debt targets in such a way as to at least maintain a creditworthy (or investment grade) debt rating. 5.Opportunistically exploit capital-market windows. Some firms debt policies vary across the capital-market cycle. Those firms issue debt when interest rates are low (and issue stock when stock prices are high) they are bargain-hunters (even th ough no bargains exist in an efficient market). Opportunism does not explain how firms set targets so much as why firms yield from those targets.