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-Modigliani[1] 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