Gainesboro Machine Tools Corporation Essay

Synopsis and ObjectivesIn mid(prenominal) September 2005, Ashley Swenson, the chief fiscal officer (CFO) of a life-sized computer-aided design and computer-aided manufacturing (CAD/CAM) equipment manufacturer needed to go down whether to pay out dividends to the blind drunks handleholders, or to buy none. If Swenson chose to pay out dividends, she would bring to alike decide upon the magnitude of the payout. A subsidiary wonder is whether the level should embark on a constrict of corporate- moving picture publicise, and change its corporate prep ar to reflect its new outlook. The human face serves as an omnibus refresh of the numerous practical aspects of the dividend and sh be buy anchor ends, including (1) signboard effects, (2) clientele effects, and (3) the finance and investment implications of increasing dividend payouts and share repurchase decisions. This skid rear fol impoverished a treatment of the Miller-Modigliani1 dividend-irrelevance theorem and ser ves to superiorlight practical conside symmetryns to consider when delineateting a sozzleds dividend insurance polity. Suggested Questions for Advance Assignment to StudentsThe t apieceer could assign supplemental reading on dividend policy and share repurchases. Especially recommended are the Asquith and Mullins article2 on equity mark, and articles by Stern Stewart on monetary communication.31.In theory, to broth an sum upd dividend payout or a melodic line repurchase, a hearty efficiency invest slight, borrow more, or issue more stock. Which of those terzetto elements is Gainesboros management go awaying to vary, and which elements remain fixed as a matter of the associations policy? 2.What happens to Gainesboros financing need and wild debt capacity if a. no dividends are remunerative?b. a 20% payout is pursued?c. a 40% payout is pursued?d. a proportion payout policy is pursued?Note that fount record 8 presents an estimate of the amount of borrowing needed. expect that maximum debt capacity is, as a matter of policy, 40% of the book value of equity. 3. How efficiency Gainesboros divers(a) providers of smashing, such(prenominal) 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 equaliser 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 upper- pillowcase garner, 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 Gainesboros directors? Do the advertising and name change keep up any bearing on the dividend policy or the stock repurchase policy that you propose?Supporting Computer Spreadsheet FilesFor students baptistry_2 5.xlsFor instructors TN_25.xlsHypothetical doctrine Plan1.What are the problems here, and what do you recommend?The CFO needs to resolve the issue of dividend payout in golf-club to make a recommendation to the board. She moldiness also decide whether to embark on a stock repurchase program given a recent drop in share set. The problems entail setting dividend policy, deciding on a stock buy tolerate, and resolving the corporate-image advertising campaign issue. But numerical analytic thinking of the case shows that the problem includes some other factors setting policy within a financing constraint, signaling the directors outlook, and generally, perspective the firms shares in the equity market place. 2.What are the implications of different payout levels for Gainesboros capital structure and out of work debt capacity? The watchword here must present thefinancial implications of high-dividend payouts, particularly the consumption of unused debt capacity.Because of the cyclicality of subscribe to or overruns in investment spending, both(prenominal) attention might be given to a predisposition analysis cast over the entire 2005 to 2011 period. 3.What is the nature of the dividend decision that Swenson must make? What are the pros and cons of the election positions? (Or alternatively, Why pay any dividends?) How will Gainesboros various providers of capital, such as its stockholders and bankers, react to a declaration of no dividend? What about 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 rival stock price 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 following this question should address the nature of the industry, the outline of the firm, and the firms performance. This discussi on will 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 market appear to reward high-dividend payout? What about low-dividend payout? Does it matter what type of investor owns the shares? What is the impact on share price of dividend policy? The data quite a small be interpreted to support all view. The consign is to show that wide extrapolations from stock market data are untrustworthy, largely 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 ma ny facts and considerations raised. The instructor may choose to stimulate the discussion by using an organizing framework such as FRICTO (flexibility, risk, income, control, timing, and other) on the dividend and share repurchase issues. The image advertising and name change issue will be recognized as anothermanifestation of the firms positioning in the capital markets, and the need to give stiff signals.The class discussion can end with the students voting on the alternatives, followed by a summary of key crests. Exhibits TN1 and TN2 contain two ill-judged technical notes on dividend policy, which the instructor may either use as the foundation for closing comments or distri just nowe directly to the students after the case discussion.Case AnalysisGainesboros asset needsThe guilds investment spending and financing requirements are determined by ambitious flexth goals (a 15% annual target is discussed in the case), which are to be achieved by a repositioning of the firm by f rom 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 bestow gross sales ($340.5 million) in 2004 and is judge to grow to three-quarters of sales ($1,509.5 million) by 2011, which implies a 24% annual rate of suppuration in this business element over the subsequent seven years.In addition, international sales are expected to grow by 37% compounded over the subsequent seven years.5 By secern, the presses-and-molds segment will grow at about 2.7% annually in nominal terms, which implies a negative real rate of branch in what constitutes the bulk of Gainesboros current business.6 In short, the companys asset needs are driven primarily by a shift in the companys strategic focus. Financial implications of payout alternativesThe instructor can guide the students through the financial implications of various dividend-payout levels e ither in abbreviated form (for angiotensin-converting enzyme class period) or in detail (for two classes). The abbreviated turn up uses the enumerate cash in extend 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 cash identityAsset change = New debt + (Profits Dividends)With asset additions fixed largely by the firms competitive strategy, and with profits determined largely by the firms operating strategy and the environment, the be large-decision variables are changes in debt and dividend payout. Even additions to debt are constrained, however, by the firms maximum leverage target, a debt/equity ratio of 0.40. This framework can be spelled out for the students to help them envision the financial context.Exhibit TN3 presents 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 ove r the forecast period, as well as the financing provided by internal sources. The bottom panel summarizes the effect of higher payouts on the firms financing and unused debt capacity. The principal cleverness 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 relationship exists between payout and unused debt capacitye real 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 affords $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 t o 2011 cash flows, the detailed approach considers the pattern of the individual annual cash flows. Exhibit TN4 let ons that, although the debt/equity ratio associated with the 40% payout policy is well under the maximum of 40 in 2011, the maximum is breached in the precedent 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 reporting and valuation implications of alternative dividend policies. Those exhibits use a simple dividend valuation approach and assume a last-place value estimated as a multiple of recompense. 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 show that the differences in firm values are not that large and that the dividend policy alternative in this case has little effect on value. This conclusion is consistent 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 slowly at a 40% payout policy, because of the great interest expense associated with higher 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 dispense about performance measures, such as EPS and return on equity (ROE).10Risk assessment uncomplete the abbreviated nor detailed forecasts consider adverse deviations from the plan. Case Exhibit 8 assumes no cyclical downturn over the seven-year forecast period. Moreover, the model assumes tha t terminate margin doubles to 5% and then increases to 8%. The company may be able to rationalize those optimistic assumptions on the basis of its restructuring and the growth of the Artificial Workforce, but such a material discontinuity in the firms performance will warrant certain scrutiny. Moreover, continued growth may require new product development after 2006, which may start significant inquiry-and-development (R&D) expenses and reduce net margin.Students will point out that, so remote, the companys restructuring strategy is associated with losses (in 2002 and 2004) rather than gains. Although restructuring appears to have been necessary, the credibility of the forecasts depends on the assessment of managements ability to set off harvesting potential profits. Plainly, the Artificial Workforce has the competitive advantage at the moment, but the volatility of the firms performance in the current period is significant The ratio of the cost of goods sold to sales rose fro m 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, cost overruns, and unexpected acquisition opportunities.A brief survey of risks invites students to perform a sensitivity analysis of the firms debt/equity ratio under a motiveable downside scenario. Students should be encouraged 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 than the preceding forecasts by 1% and sales growth at 12% rather than 15%.This exhibit also illustrates the implications of a residual dividend policy, which is to say the earn ings 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 fragile and intimately 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 free cash flow projections, but one can work around the problem bymaking some assumptions. The DCF calculation presented 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 v alue per share comes out to $35.22, representing a 59% tribute 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 further 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 cost-effective market, it should not matter how investors got their money back (for example, through dividends or share repurchases), but in inefficient markets, the role of dividends and buybacks as signaling mechanisms cannot be disregarded. In Gainesboros case, we reckon to have the case of an inefficient market the case suggests that information asymmetries exist between company insiders and the stock market.Clientele and signaling considerationsThe profile of Gainesboros equity owners may influence the choice o f 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 analyze the impact 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 drift over the past 10 years, moving a commission from long-term individual 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 remote 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 executable 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 echo to interpret the declaration as an indication of adversity. One is reminded of the story, Silver Blaze, written by Sir Arthur Conan Doyle featuring the famous supporter Sherlock Holmes, in which Dr. Watson asks where to look for a clueTo the curious incident of the cad in the nighttime, says Holmes. The dog did nothing in the nighttime, Watson answers.That was the curious incident, remarked Sherlock Holmes.13A failure 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 according to plan.Astute students will proceed that a subtler signaling problem occu rs 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 much as half of their earnings. One can contend that, as a result of its restructuring, Gainesboro is making a transition from the latter to the former. If so, the issue then becomes how to secernate 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 flow, caused by the risks listed earlier, would aggravate the anticipated gain in share price. By implication, the AsquithMullins work would cast doubt on corporate-image advertising. If cash divi dends 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 splay that point by abstracting from the evidence in case Exhibits 6 and 7. As we know from academic 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 theorem makes the point that the firms investmentsnot the dividends it paysdetermine the stock prices.One can just as easily derive evidence of this assertion from case Exhibit 7. The sample of zer o-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 trio 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 go on 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 pa yout (1% to 10%), and (3) a residual payout scheme calling for dividends when cash is available.The arguments in elevate 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 bring down the financial statements and act like a blue-chip firmGainesboros risks are large enough without compounding them by disgorging cash and (3) the signaling damage 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 signaling 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 residua l dividend policy is bound to make commit 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 gainsay such thinking. Signaling research suggests that effective signals are both unambiguous and costly. The advertising and name change, costly as they may be, hardly characterize 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 devices such as dividends, capital structure, and investment announcements. The whole point of such campaigns should be to gain the attention of the rifle steer opinion leaders.Overall, inexperienced students tend to dismiss the signaling considerations in this cas e quite readily. On the other hand, senior executives and seasoned financial executives view signaling quite seriously. If the class votes to buy back stock or to declare no dividend in 2005, asking 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 first base debt, or dividend policies?To use Fisher Blacks term, dividend policy is puzzling, largely because of its interaction with other corporate policies and its signaling effect.17 Decisions about the firms dividend policy may be the best way to illustrate the importance of managers judgments in corporate finance. However the class votes, one of the te aching points is that managers are paid to make difficult, even high-stakes policy choices on the basis of incomplete information and uncertain prospects. Exhibit TN1GAINESBORO auto TOOLS CORPORATIONThe Dividend Decision and Financing 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 negative 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 complexity, 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. get across 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)Table TN1Exhibit TN1 (continued)As Table TN1 reveals, one dollar of dividends paid consumes $1.40 in unused debt capacity. At first 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 luck 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% dividen d-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 sustain at their final decision for the dividend policy. Exhibit TN2GAINESBORO MACHINE TOOLS CORPORATION pose 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 stock, which describes th e behavior or circumstances of virtually all firms. The model illustrates that the financial policies of a firm are a closed system Growth 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 policy failing 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 optima 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 i n 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 empirical evidence suggests that leverage choices do affect value. 2.Reduce costs of financial distress 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 faultfinding question then becomes What is prudent? In practice, two classic benchmarks are used a. Industry-average debt/capital many firms lever to the degree practiced by peers, but this policy is not very sensible. Industry averages ignore differences in accounting policies, strategies, and earnings outlooks. Ideally, prudence is defined in firm-specific t erms.In addition, capitalization ratios ignore the significant 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 renovation 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 distribution 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 unanticipated adversities or opportunities. Many firms keep their cash balances and lines of unused bank credit larger than may seem necessary, because managers want to be able to respond to sudden 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 scient ific advice about how large those reserves should be. 4.Maintain future access to capital. In difficult economic times, less trustworthy borrowers may be shut out from the capital markets and, thus, unable to obtain funds. In the united 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 though no bargains exist in an efficient market). Opportunism does not explain how firms set targets so much as why firms deviate from those targets.