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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-

aided design and

computer-aided
manufacturing
(CAD/CAM)
equipmentmanufac
turer needed to
decide whether to
pay out dividends
to the firms

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

and share buyback

decisions, includi
ng (1)
signalingeffects,
(2) clientele
effects, and (3) the
finance and
investment
implications of

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

issue more stock.

Which of those
three elements
isGainesboros
management
willing to vary,
and which
elements remain
fixed as amatter of

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

of debt and equit

y; if the cost of
capital changes,
so may the value
of the firm.Unfo
rtunately, 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

financialofficers
and their advisors.
The Gainesboro
case illustrates the
impact of dividend
payouton
creditworthiness.

Setting Debt and

Dividend-Payout
Targets
The Gainesboro
Machine Tools
Corporation case
well illustrates the
challenge
of setting the two

most obvious
components of
financial policy:
target payout and
debtcapitalization.
The policies are
linked with the
firms growth
target, as shown in

the selfsustainable growth

model:g
ss

= (P/S S/A
A/E)(1
DPO)Where:g
ss

is the selfsustainable 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 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.

The model offers

the key
insight that no
financial policy
can be set without
reference to the
others.
As Gainesboro
shows,
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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

ization ratios ign

ore the crucial fac
t 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
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

ain a reserve agai

nst
unforeseen advers
ities or opportunit
ies. Many firmske
ep their cash
balances and lines
of unused bank
credit larger than

may
seemnecessary,
because managers
want to be able to
respond to sudden
demands onthe
firms financial
resources caused,
for example, by a

price war, a large

productrecall, or
an opportunity to
buy the toughest
competitor.
Academicians
have noscientific
advice about how
large those

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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