Case #25

Gainesboro Machine Tools Corporation

Synopsis and Objectives

In mid September 2005, Ashley Swenson, the chief financial officer (CFO) of a
large computer-aided design and computer-aided manufacturing (CAD/CAM) equipment
manufacturer needed to decide whether to pay out dividends to the firm’s shareholders, or
to repurchase stock. If Swenson chose to pay out dividends, she would have to also
decide upon the magnitude of the payout. A subsidiary question is whether the firm
should embark on a campaign of corporate-image advertising, and change its corporate
name to reflect its new outlook. The case serves as an omnibus review of the many
practical aspects of the dividend and share buyback decisions, including (1) signaling
effects, (2) clientele effects, and (3) the finance and investment implications of increasing
dividend payouts and share repurchase decisions. This case can follow a treatment of the
Miller-Modigliani1 dividend-irrelevance theorem and serves to highlight practical
considerations to consider when setting a firm’s dividend policy.

Suggested Questions

1. In theory, to fund an increased dividend payout or a stock buyback, a firm might

invest less, borrow more, or issue more stock. Which of those three elements is
Gainesboro’s management willing to vary, and which elements remain fixed as a
matter of the company’s policy?
2. What happens to Gainesboro’s financing need and unused debt capacity if:
a. no dividends are paid?
b. a 20% payout is pursued?
c. a 40% payout is pursued?
d. a residual payout policy 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 Gainesboro’s various providers of capital, such 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 residual 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?

1 Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation
of Shares,” Journal of Business 34 (October 1961): 411–433.
 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 advertising campaign and
corporate name change to the Gainesboro’s directors? Do the advertising and
name change have any bearing on the dividend 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. 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 firm’s 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.

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 debt
capitalization. The policies are linked with the firm’s growth target, as shown in the self-
sustainable growth model:

gss = (P/S × S/A × A/E)(1 − DPO)

Where:

gss is the self-sustainable growth rate

P is net income
S is sales
A is assets
E is equity
DPO is the dividend-payout ratio

This 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. 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 firm’s ability to achieve growth and capitalization
targets and vice versa. Myopic policy—failing to manage the link among the financial
targets—will result in the failure to meet financial targets.

Setting Debt-Capitalization Targets

Finance 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 firm’s debt-capitalization targets.
Several classic competing considerations influence the choice of debt targets:

1. Exploit debt-tax shields. Modigliani and Miller’s 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 empirical evidence suggests that leverage choices do
affect value.
2. Reduce costs of financial distress and bankruptcy. Modigliani and Miller’s theory
naively implied that firms should 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/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 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 distribution of EBIT and setting the
debt-capitalization level, so that the probability of covering debt service is
consistent with management’s 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 larger than may seem
necessary, because managers want to be able to respond to sudden demands on
the firm’s 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.

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.
 4. Maintain future access 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 United States, “less creditworthy” refers to the companies whose
debt ratings are less than investment grade (which is to say, less than BBB 2 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.

Setting Dividend-Payout Targets

In theory, dividend policy should have no effect on the value of a firm’s shares.
Nonetheless, dividend-payout decisions absorb so much of the time of highly paid,
intelligent senior executives that dividend payout must be important economically. These
are the key considerations that emerge in payout decisions:

1. Financing attractive investments: Miller and Modigliani’s famous dividend-

irrelevance theorem suggests that dividend policy should be set as a residual—
that is, the real question to ask is whether and how the firm can finance all of its
positive net present value (NPV) investment opportunities. Under that view,
dividends paid out are simply the cash flow that remains after a firm makes
attractive investments.
2. Sending signals: Executives do not want to tell the world what they foresee for
their companies, because that projection would telegraph their moves to their
competitors. Paying progressively higher dividends is one way to convey
optimism about the future. The investment community, however, forms its own
expectations about the firm’s future and dividend payments. Dividends have
signaling content when they deviate from investors’ expectations. A surprisingly
high or low change in dividend payments conveys news to investors. Cutting a
dividend (even to finance an attractive investment) is universally perceived as bad
news.
3. Building a reputation: Academic research finds that dividend payments “ratchet”
up: they tend to rise or hold steady, but only fall rarely. Many companies
advertise their unbroken string of annual dividend increases. Managers believe
that dividend payout builds a reputation of investment performance.

2 BBB is the lowest investment-grade bond rating awarded by Standard & Poor’s, a
bond-rating agency.
3 Baa is the lowest investment-grade bond rating awarded by Moody’s Investment
Service, a bond-rating agency.
 4. Segmenting the capital market and attracting an investor clientele: If capital
markets are not homogeneous, some investors will pay more for the share of high-
payout firms and others will pay less. From that point of view, CFOs should be
like consumer marketers, aiming to position their product (for example, their
shares) to the investor clientele that is willing to pay the most. The firm’s choice
of dividend payout may influence the position of its shares. This view is
provocative and not easily implemented for large public corporations. On the
other hand, this consideration is enormously important for privately owned
businesses, because it suggests that managers should listen to the owners’ needs
for cash.

Conclusion

Corporate debt and dividend policies emerge after weighing difficult trade-offs
among competing desirable ends. No algorithm or model straightforwardly dictates
policies. As analysts and managers, we confront the need to run the decision process well
by ensuring that all trade-offs surface and that all arguments are heard. Ultimately, good
policies meet these three tests:

1. Do they create value?

2. Do they create a competitive advantage?
3. Do they sustain the company’s managerial vision?