GAINESBORO MACHINE TOOLS CORPORATION

Teaching Note

Synopsis and Objectives

Other cases in which dividend policy is an important issue: “Deutsche Brauerei,” (Case 11)
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 dividend-irrelevance theorem and serves to highlight practical considerations to consider when setting a firm’s dividend policy. Suggested Questions for Advance Assignment to Students

The instructor could assign supplemental reading on dividend policy and share repurchases. Especially recommended are the Asquith and Mullins article on equity signaling, and articles by Stern Stewart on financial communication.

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