UV1384
Rev. Jun. 21, 2012
GAINESBORO MACHINE TOOLS CORPORATION
Teaching Note
Synopsis and Objectives
In mid-September 2005, Ashley Swenson, the chief financial Other cases in which
officer (CFO) of a large computer-aided design and computer-aided dividend policy is an
manufacturing (CAD/CAM) equipment manufacturer needed to decide important issue:
whether to pay out dividends to the firm’s shareholders, or to repurchase “Deutsche Brauerei,”
(UVA-F-1355)
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.
1
Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of
Business 34 (October 1961): 411–33.
, -2- UV1384
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 article2 on equity signaling,
and articles by Stern Stewart on financial communication.3
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?
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?
Supporting Excel Spreadsheet Files
For students: UVA-F-1489X
For instructors: UVA-F-1489TNX
2
Paul Asquith and David W. Mullins Jr., “Signaling with Dividends, Stock Repurchases, and Equity Issues,”
Financial Management (autumn 1986): 27–44.
3
“How to Communicate with an Efficient Market,” and “A Discussion of Corporate Financial
Communication,” Midland Corporate Finance Journal 2 (spring 1984).
, -3- UV1384
Hypothetical Teaching Plan
1. What are the problems here, and what do you recommend?
The CFO needs to resolve the issue of dividend payout in order to make a
recommendation to the board. She must also decide whether to embark on a stock
repurchase program given a recent drop in share prices. The problems entail setting
dividend policy, deciding on a stock buyback, and resolving the corporate-image
advertising campaign issue. But numerical analysis of the case shows that the problem
includes other factors: setting policy within a financing constraint, signaling the directors’
outlook, and generally, positioning the firm’s shares in the equity market.
2. What are the implications of different payout levels for Gainesboro’s capital structure
and unused debt capacity?
The discussion here must present the financial implications of high-dividend payouts,
particularly the consumption of unused debt capacity. Because of the cyclicality of
demand or overruns in investment spending, some attention might be given to a
sensitivity analysis cast over the entire 2005–11 period.
3. What is the nature of the dividend decision that Swenson must make? What are the pros
and cons of the alternative positions? (Or alternatively, why pay any dividends?) How
will Gainesboro’s various providers of capital, such as its stockholders and bankers,
react to a declaration of no dividend? What about the announcement of a 40% payout?
How would they react to a residual payout?
The instructor needs to elicit from the students the notions that the dividend-payout
announcement may affect stock price and that at least some stockholders prefer
dividends. Students should also mention the signaling and clientele considerations.
4. What risks does the firm face?
Discussion following this question should address the nature of the industry, the strategy
of the firm, and the firm’s performance. This discussion will lay the groundwork for the
review of strategic considerations that bears on the dividend decision.
5. What is the nature of the share repurchase decision that Swenson must make? How
would this affect the dividend decision?
The discussion here must present the repercussions of a share repurchase decision on the
share price, as well as on the dividend question. Signaling and clientele considerations
must also be considered.
6. Does the stock market appear to reward high-dividend payout? What about low-dividend
payout? Does it matter what type of investor owns the shares? What is the impact on
share price of dividend policy?
Rev. Jun. 21, 2012
GAINESBORO MACHINE TOOLS CORPORATION
Teaching Note
Synopsis and Objectives
In mid-September 2005, Ashley Swenson, the chief financial Other cases in which
officer (CFO) of a large computer-aided design and computer-aided dividend policy is an
manufacturing (CAD/CAM) equipment manufacturer needed to decide important issue:
whether to pay out dividends to the firm’s shareholders, or to repurchase “Deutsche Brauerei,”
(UVA-F-1355)
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.
1
Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of
Business 34 (October 1961): 411–33.
, -2- UV1384
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 article2 on equity signaling,
and articles by Stern Stewart on financial communication.3
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?
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?
Supporting Excel Spreadsheet Files
For students: UVA-F-1489X
For instructors: UVA-F-1489TNX
2
Paul Asquith and David W. Mullins Jr., “Signaling with Dividends, Stock Repurchases, and Equity Issues,”
Financial Management (autumn 1986): 27–44.
3
“How to Communicate with an Efficient Market,” and “A Discussion of Corporate Financial
Communication,” Midland Corporate Finance Journal 2 (spring 1984).
, -3- UV1384
Hypothetical Teaching Plan
1. What are the problems here, and what do you recommend?
The CFO needs to resolve the issue of dividend payout in order to make a
recommendation to the board. She must also decide whether to embark on a stock
repurchase program given a recent drop in share prices. The problems entail setting
dividend policy, deciding on a stock buyback, and resolving the corporate-image
advertising campaign issue. But numerical analysis of the case shows that the problem
includes other factors: setting policy within a financing constraint, signaling the directors’
outlook, and generally, positioning the firm’s shares in the equity market.
2. What are the implications of different payout levels for Gainesboro’s capital structure
and unused debt capacity?
The discussion here must present the financial implications of high-dividend payouts,
particularly the consumption of unused debt capacity. Because of the cyclicality of
demand or overruns in investment spending, some attention might be given to a
sensitivity analysis cast over the entire 2005–11 period.
3. What is the nature of the dividend decision that Swenson must make? What are the pros
and cons of the alternative positions? (Or alternatively, why pay any dividends?) How
will Gainesboro’s various providers of capital, such as its stockholders and bankers,
react to a declaration of no dividend? What about the announcement of a 40% payout?
How would they react to a residual payout?
The instructor needs to elicit from the students the notions that the dividend-payout
announcement may affect stock price and that at least some stockholders prefer
dividends. Students should also mention the signaling and clientele considerations.
4. What risks does the firm face?
Discussion following this question should address the nature of the industry, the strategy
of the firm, and the firm’s performance. This discussion will lay the groundwork for the
review of strategic considerations that bears on the dividend decision.
5. What is the nature of the share repurchase decision that Swenson must make? How
would this affect the dividend decision?
The discussion here must present the repercussions of a share repurchase decision on the
share price, as well as on the dividend question. Signaling and clientele considerations
must also be considered.
6. Does the stock market appear to reward high-dividend payout? What about low-dividend
payout? Does it matter what type of investor owns the shares? What is the impact on
share price of dividend policy?
