CF case 3

Cooperate Finance

Analysis of Gainesboro Machine Tools

Corporation

吴桐毅(Denis Wu)1221106

叶君卓(Devon Ye)12211

王文靓(Rachel.Wang）12211211

The background of the company

Gainesboro Corporation was founded in 1923 in Concord. In early days, it had designed and manufactured a number of machinery parts, including metal press, dies, and molds. By 1975, the company had developed as an innovative producer of industrial machinery and machine tools. During 1980s, the firm entered in the industry of computer-aided design (CAD) and computer-aided manufacturing (CAM), and later on became an industrial leader. However, aggressive entry of large foreign firm dampened sales throughout 1990s. From 1998 to 2004 Gainesboro’s revenues decreased from $911 million to $757 million. The company underwent two restructuring initiatives in 2002 and 2004 with a total cost of $202 million. In the first few years of 2000s, the company’s restructurings had improved efficiency and development of Artificial Workforce system. With creation of applications for the trucking, automobile-parts and airline industries, Gainesboro is expected to have good growth in future.

The issue of the case

In mid-September 2005, Ashley Swenson, the chief financial officer of Gainesboro Machine Tools Corporation must decide whether to pay out dividends to the firm’s shareholders or repurchase stock. If she chooses to pay out dividends, she must also decide on the number of the payout. A other question is whether the firm should carry on a campaign of corporate-image advertising and change its corporate name to reflect its new corporate outlook. This case includes many practical aspects of the dividend and share buyback decisions, such as signaling effects, clientele effects, and finance and investment implications of increasing dividend payout and share repurchase decisions. Swenson has contemplated her options down to three alternative options.

These are ways to settle down this problem by defining the dividend policy.

1. Zero-dividend payout policy –does not pay a dividend. Reflected the huge cash requirements of investment in advanced technologies and CAD/CAM, the firm should take the retained earnings and add them to the cash used to invest in the operations which generate growth in the future business. Sending a clear signal to internal management and external investors, this policy indicates that the company had made the transition from a traditional industry to a high-tech enterprise. While breaking the Gainesboro’s tradition, this solution could also be justified by investors as the company is on the way of getting new competitive advantages through investment in state-of-the-art technologies with the trend of zero- dividend payout.

2. 40% dividend payout policy – the most favorable policy that fits shareholders’ expectation. The second option involves a 40% dividend payout, with an implied annual dividend payment of $0.80 per share. Some investment bankers argue that investors would consider this as a signal that the company had conquered its problem and the management was confident of its future earnings. Meanwhile, the growth oriented investors who were looking for future appreciation of stock price would consider this approach as a shortsighted solution. In the end, using debt to pay for this dividend for some time, the company would suffer a shortage of cash flow, which was a controversial issue for investors who dislike the use of debt.

3. Residual-dividend payout policy –only after financing all the projects that provide positive net cash value (NPV), the residual funds are distributed to shareholders. By deploying funds into those projects, proponents of this argument insisted that such an approach would ensure that all

projects were being properly funded to ensure future growth and dividend payout was based on the sufficient supports to company’s long-term development. Rather than try hard to maintain a predetermined dividend payout, the firm had less pressure on cash flow and future growth than other options.

Evaluation of different choices

1. Zero- dividend payout

The proponents of zero-dividend payout consider the fact that the company is growing and it needs to reinvest all earnings to implement its goals of expansion with solution to the company’s problem of cash since it would not need to borrow to pay the dividend. According to the case, 7 out of 8 CAD/CAM companies were not paying any dividends even though they were all expecting significant growth. Meanwhile, electrical-industrial equipment manufacturers or machine tool manufacturers were paying almost up to a 3.1 yield on shares (Exhibit 6). This payout policy would help the firm create its brand image as advanced software and hardware company rather than a traditional manufacturer by the company’s strategy. Last but not the least, the dividend tax would be avoided as the gain in capital value is not taxed, saving a lot of money for the firm’s future development.

Opponents of this project said that managers would lose their credibility since they have already promised to pay dividend payout during the year and many investors would be disappointed by the change in dividend policy causing a drop in share prices resulted from the clientele effect. Considering the Information signaling effects, we would forecast investors may take it as a negative signal indicates that there are some huge difficulties inside the company.

2. 40 percent dividend payout or a dividend of $0.20 a share

In the pros aspect of the policy, investors would interpret it as a positive sign that the company had a good performance conquering its business difficulties due to the Information signaling effect. With the debt-to-equity ratio was still under 40%, cash flow pressure was still under control. As a result of this solution, m anagers’ credibility would increase as they were loyal to their predetermined dividend payout.

However, in the opposite point of view, the company would need to borrow some money and the board members would not appreciate such a sudden increase in debts although within the set limits. In fact, the 15% growth prediction was the most optimistic approach and if something did not go as the predictions, the company would experience serious problems due to ripple effect. According to traditional manufacturers’ 40% payout ratio, it would damage the firm’s hi-tech image, showing the company was still under the mindset of traditional strategy.

3. Residual- Dividend payout policy

Supporters of this view argued that the company would maximize its value by funding all projects that have a positive NPV with no liquidity problems and on needs in the company to increase its equity-to-debt ratio.

But, according to the clientele effect, few or no new investors would be attracted due to the unclear dividend policy. Therefore, investments would flow to other companies with a steady and guaranteed return. As the prediction of Information signaling, the image of the company might

be damaged, suggesting investors that the company was going through an unsteady process of development.

4. Funding and borrowing to pay dividend.

Form the shareholders’point of view, they were not very interested in increasing the company`s debt as they prefer to use its own resources, even though it was not efficient, this attitude was still strong at management level. It would be in the company`s interest to increase the amount of loan debts because it was cheaper than equity debts. The traditional views supported this in lower levels of the debt and equity ratio. In this particular case though, this might not be true because the usage of the loan to pay shareholders would be considered as a risky activity by the bank and as a result it would ask for a higher interest rate

5. Repurchase of shares

Shareholders would prefer a repurchase of shares as they would enjoy share prices increase in value in this way if they held it during this period or they can gain the return coming from the positive difference in buying their shares cheap and selling them high.

6. Corporate image advertising

For the objective of corporate image advertising, paying dividend will increase the brand awareness and might increase share price in the short term. However, there were not empirical evidence to prove this high cost assumption.

Recommendation to Swenson

Considering creating a competitive advantage and sustainable company’s vision, implementing the zero-dividend payout approach is our recommendation to Ashley Swenson as it allows her to offer the company to gain the greatest number of financial goals. First, a zero-dividend payout solution will maximize excess cash allowing the company to pursue more aggressive marketing objectives. Secondly, cash saved for technological projects will give the company an ability to gain future expansion and investment. Thirdly, it provides the flexibility for the company to minimize interest expense and dividend expense which could negatively impact its net income goals.

The one goal that this strategy does not fulfill is Stephen Gaines’ idea of returning to a steady dividend payout as soon as possible. Many investors believe a strong dividend is an indicator of a strong company even though the management board is likely to support this approach. Swenson can convince the opponents that this is a must decision for a hi-tech company with a growing trend when we analyze all listed companies which have similar developing process in their history.