Case #25gainesboro Machine Tools
Case #25gainesboro Machine Tools
Case #25gainesboro Machine Tools
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Case 25 Notes
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Published by Rohit Aggarwal
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Case
#25Gainesboro
Machine Tools
OF 5
CorporationSyno
psis and
Objectives
In mid September
2005, Ashley
Swenson, the
chief financial
officer (CFO) of
alarge computer-
shareholders, or to
repurchase stock.
If Swenson chose
to pay out
dividends, she
would have to
alsodecide upon
the magnitude of
the payout. A
subsidiary
question is
whether the
firmshould
embark on a
campaign of
corporate-image
advertising, and
change its
corporatename to
reflect its new
outlook. The case
serves as an
omnibus review
of the
many practical
aspects of the
dividend
increasingdividend
payouts and share
repurchase
decisions. This
case can follow a
treatment of
theMillerModigliani
1
dividendirrelevance theore
m and serves to h
ighlight practical
considerations to
consider when
setting a firms
dividend policy.
Suggested
Questions
1.In theory, to
fund an increased
dividend payout
or a stock
buyback, a firm
mightinvest less,
borrow more, or
the companys
policy?2.What
happens to
Gainesboros
financing need
and unused
debt capacity
if:a.no dividends
are paid? b.a
20% payout is
pursued?c.a
40% payout is pu
rsued?d.a
residual payout p
olicy 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
Gainesboros
various providers
of capital, such as
its stockholders
andcreditors, rea
ct if Gainesboro
declares a divide
nd in 2005? Wha
t are theargument
s for and against
the zero payout,
40% payout, and
residual
payout policies?
What should
Ashley Swenson
recommend to the
board of directors
withregard to a
long-term
dividend payout
policy for
Gainesboro
Machine
ToolsCorporation
?1 Merton Miller
and Franco
Modigliani,
Dividend Policy,
Growth, and the
Valuationof
Shares,
Journal of
Business
34 (October 1961):
411433.
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4. How
might various
providers of
capital, such as
stockholders and
creditors, reactif
Gainesboro
repurchased its
shares? Should
Gainesboro do
so?5.Should Swe
nson recommend
the corporateimage advertisin
g campaign andc
orporate name
change to the
Gainesboros
directors? Do the
advertising
andname change
have any
bearing on the di
vidend policy
or the stock
repurchase policy
that you propose?
The Dividend
Decision and
Financing Policy
The dividend
decision is
necessarily part of
the financing
policy of the firm.
Thedividend
payout chosen
may affect the
creditworthiness
of the firm and
hence the costs
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
financialofficers
and their advisors.
The Gainesboro
case illustrates the
impact of dividend
payouton
creditworthiness.
most obvious
components of
financial policy:
target payout and
debtcapitalization.
The policies are
linked with the
firms growth
target, as shown in
= (P/S S/A
A/E)(1
DPO)Where:g
ss
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 the
behavior or
circumstances of
virtually all firms.
Themodel
illustrates that the
financial policies
of a firm are a
closed system:
Growth
rate,dividend
payout, and debt
targets are
interdependent.
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a high dividend
payout affects the
firms ability to
achieve growth
and
capitalizationtarge
ts and vice versa.
Myopic policy
failing to manage
the link among
the
financialtargets
will result in the
failure to meet
financial targets.
Setting DebtCapitalization
Targets
Finance theory is
split on whether
gains are created
by optimizing the
mix of debtand
equity of the firm.
Practitioners and
many
academicians,
however, believe
that debtoptima
exist and devote
great effort to
choosing the
firms debt-
capitalization
targets.Several
classic competing
considerations
influence the
choice of debt
targets:1.Exploit d
ebt-tax shields.
Modigliani and
Millers theorem
implies that in
theworld 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
createvalue. 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
theorynaively
implied that firms
should lever up to
99% of capital.
Virtually no firms
dothis. Beyond
some prudent
level of debt, the
cost of capital
becomes very
high because
investors
recognize that the
firm has a greater
probability of
sufferingfinancial
distress and
bankruptcy. The
critical question
then becomes:
What isprudent?
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. Industr
y averages ignore
differences in acc
ounting policies,
strategies, and ear
nings outlooks.Id
eally, prudence i
s defined in firm
specific terms. I
n addition,capital
Firm-specific
debt service
: More firms are
setting debt
targets based
onthe forecasted
ability to cover pr
incipal and intere
st payments withe
arnings before in
terest and taxes (
EBIT). This prac
tice requiresforec
asting the annual
probability
distribution of
EBIT and setting
thedebt-
capitalization
level, so that the
probability of
covering debt
service
isconsistent with
managements
strategy and risk
tolerance.3.Maint
may
seemnecessary,
because managers
want to be able to
respond to sudden
demands onthe
firms financial
resources caused,
for example, by a
reserves should
be.1
Actually, value is
transferred from
the public sector,
as a loss of tax
revenue, to
the private sector.
From a
macroeconomic
standpoint, no
value has been
created.
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