Task:

Mid September 2005, Ashley Swenson, CFO of Gainesboro, a large computer-aided design and manufacturing (CAD/CAM) equipment maker, was considering paying out dividends to the firm’s shareholders or to repurchase shares.

It is your task to analyse and report whether she should pay out dividends or repurchase shares (or none), and the optimal amount of the payout. Your response should cover (but not necessarily limited to) the following questions:

1. What happens to Gainesboro’s financing need and unused debt capacity if: no dividends are paid? a 20% payout is pursued? a 40% payout is pursued? a residual payout policy is pursued?

2. How might Gainesboro’s various providers of capital (shareholders and creditors) react if Gainesboro declared a dividend in 2005? What are the arguments for and against the zero payout, 40% payout, and residual payout policies?

3. How might various providers of capital (shareholders and creditors) react if Gainesboro repurchased its shares? Should Gainesboro do so?

Length:

Max 1000 words, excluding figures/tables/references.

Due Date:

Friday week 8 at 17:00 hrs EST.

1. What happens to Gainesboro’s financing need and unused debt capacity if: no dividends are paid? a 20% payout is pursued? a 40% payout is pursued? a residual payout policy is pursued?

No dividend

10% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 10% 10% 10% 10% 10% 10% 10%3. Dividend Payout Ratio 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Excess cash/(Borrowing needs) (23.5)$ (10.7)$ (3.0)$ (0.3)$ 11.2$ 4.3$ 34.9$

15% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 15% 15% 15% 15% 15% 15% 15%3. Dividend Payout Ratio 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Excess cash/(Borrowing needs) (22.7)$ (7.3)$ 4.2$ 11.5$ 29.4$ 27.2$ 77.6$

20% Dividend

10% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 10% 10% 10% 10% 10% 10% 10%3. Dividend Payout Ratio 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%Excess cash/(Borrowing needs) (26.9)$ (18.0)$ (13.0)$ (12.5)$ (3.4)$ (10.7)$ 11.4$

15% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 15% 15% 15% 15% 15% 15% 15%3. Dividend Payout Ratio 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%Excess cash/(Borrowing needs) (26.3)$ (15.3)$ (7.3)$ (3.0)$ 11.1$ 7.6$ 45.6$

30% Dividend

10% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 10% 10% 10% 10% 10% 10% 10%3. Dividend Payout Ratio 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0%Excess cash/(Borrowing needs) (28.7)$ (21.7)$ (18.1)$ (18.6)$ (10.8)$ (18.2)$ (0.3)$

15% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 15% 15% 15% 15% 15% 15% 15%3. Dividend Payout Ratio 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0%Excess cash/(Borrowing needs) (28.1)$ (19.3)$ (13.1)$ (10.3)$ 2.0$ (2.2)$ 29.6$

40% Dividend

10% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 10% 10% 10% 10% 10% 10% 10%3. Dividend Payout Ratio 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%Excess cash/(Borrowing needs) (30.4)$ (25.3)$ (23.1)$ (24.7)$ (18.1)$ (25.7)$ (12.0)$

15% Growth

2005 2006 2007 2008 2009 2010 20111. Sales Growth Rate: 15% 15% 15% 15% 15% 15% 15%3. Dividend Payout Ratio 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%Excess cash/(Borrowing needs) (29.9)$ (23.3)$ (18.8)$ (17.6)$ (7.2)$ (12.0)$ 13.6$

Residual Dividend Policy

Typically, this method of dividend payment creates volatility in the dividend payments that may be undesirable for some investors.

With 15% Growth - Dividends will be paid from 2007 to 2011 – However this will substantially effect the financial flexibility of the firm

With 10% growth – Dividends will be paid from 2009-2011 – Undesirable for shareholders and once again will affect the financial flexibility of the firm.

2. How might Gainesboro’s various providers of capital (shareholders and creditors) react if Gainesboro declared a dividend in 2005? What are the arguments for and against the zero payout, 40% payout, and residual payout policies?

If a dividend payment is made, the effect to shareholders and creditors will be a lower share price however, the shareholders will receive dividends.

N.B. It should be highlighted that the trade-off between share repurchase and dividend payout does not affect the total value of the share capital or the total expected return on the capital. The real payoff between these two decisions is a lower priced share and a dividend or a higher share price and no dividend.

Zero Payout

Pros:

Growing company – requires plough back and retained earnings Borrowing excess cash for dividend payment can be avoided Can be positioned as high growth and high tech firm In recent years, companies not paying dividends has increased Cash flow will be positive in 2007 assuming 15% growth is sustainable

Cons:

Commitment? Value-oriented investors (13%) & Long Term retiree’s (26%) require dividends EPS falls from 1.03 to almost 0 – negative signalling this sends to shareholders/the market

40% Payout

Pros:

In line with shareholder expectations $0.8/Share – highest payout since 2001

o Signals positive signs to the market/shareholders

Cons:

Unnecessary increase in debt levels For growth, company requires plough back 15% growth is overly optimistic – these growth levels are not usually sustainable Even with unsustainable growth – CF’s are not positive until post 2011 With realistic growth rate of 10% - CF’s are still -12M at 2011

Residual Payout

Pros:

Minimises new stock issues and flotation costs

Cons:

Results in variable dividend payouts Sends conflicting signal to market and investors/ shareholders Increases risk

Does not appeal to any specific clientele

Thus Gainesboro should consider residual policy to help set their long run target payout rations, but not as a guide to the dividend payout in any one year

3. How might various providers of capital (shareholders and creditors) react if Gainesboro repurchased its shares? Should Gainesboro do so?

If a buyback program is implemented, the effects to shareholders and creditors will be that the share price of the firm will increase; however, the shareholders will not receive a dividend. This then comes back to time value of money, would shareholders prefer to receive a payment now, or in a years’ time? Definitely today as shareholders are the best maximisers of their own funds and the money will also be worth more to them today if then in the future. Additionally, reducing the FCF will prevent agency costs.

How will they react? In terms of signalling from this – shareholders would potentially be unhappy as they have not received a dividend. However, from a creditor’s perspective, the share price of the firm will increase which will send positive signals to investors and creditors. The fact that a dividend has not been paid however will send negative signals to providers of capital as it indicates that the board is not confident in the future prospects of the company and additionally, that the company is not performing as well as they previously have (they have paid higher dividends in the past and obviously have not received they same level of cashflows over the last period).

Report Structure – Case 2:

Abstract

Theories/ Arguments

Payout Options

Share Repurchase

Recommendations

Notes from Tutorial

Pros for 0% Dividend:

Max. uptake on +NPV Projects Financial Flexibility

Pros for 40% Dividend:

Signalling Clientele Effects

o Tax Purposeso Arbitrages

Dividend vs. Capital Gains Eliminating FCF – reduce agency costs (Jensen 1986 – Agency Theory)

Theory - MM says that firm value is irrelevant of payout policy. Except to the extent that it may influence real investment decisions. This may occur because “incomplete information/asymmetric information”

o Problem of “adverse selection” Credibly signals the firms true value

o Eliminating the FCF creates incentives for managers to pick only the best +NPV projects Analysis – How to pay out? Div vs Repurchase?

o Repurchase is more flexible – do them whenever you want Open market repurchases – buy over time Recap benefits of signalling, but no commit to a set payout level

o Managers only sell you a stock when its overvaluedo Managers will only buy a stock from you when its undervalued

If firm has excess FCF and unused debt capacity – vulnerable to hostile take-over or potential leverage buyout

o Showed the paper I have uploaded by Deangelo, Deangelo & Sknner (ch13 pg 429 pt 4) when discussing this