Gainesboro Case Analysis

Gainesboro Machine Tools Corporation:
Payout Policy for a New Identity
(Case 8 Analysis)

Presented March 10, 2008
to Dr. Tony Plath, Professor of Finance

In Partial Fulfillment of Requirements for
MBAD 6154 | Graduate Applied Financial Management
The University of North Carolina at Charlotte

Clay Fowler
Jabbar Jamison

Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008
Introduction

“Profitable companies regularly face three important questions: (1) How much of our
free cash flow should we pass on to shareholders? (2) Should we provide this cash to
stockholders by raising the dividend or by repurchasing stock? (3) Should we maintain a
stable, consistent payment policy, or should we let the payments vary as conditions
change?”
(Brigham, Ehrhardt, Ch. 18. p361)

Gainesboro Machine Tools Corporation faces these questions as their core business
evolves to meet technological innovations and increasing international demand. For
decades they were a favorite of income investors for their solid earnings and strong
dividends, but in 2005 the scene had changed. After years of planning and
restructuring, they now find themselves as a key player in a new industry. Going
forward, Gainesboro is projecting that three‐quarters of sales revenue will come from
the advanced‐technology peripherals and CAD/CAM software business, with the
remainder coming from their core business of old, electrical‐equipment and machine
tools manufacturing. Gainesboro has positioned itself for success in a new industry but
its realignment has come with significant costs – net losses of $61.3 million and $140
million, in 2002 and 2004 respectively. In the face of these extraordinary losses,
Gainesboro has tapped lines of credit in order to continue to pay high‐dividends,
ballooning debt to its highest ever. In 2004, it succumbed, cutting its dividend payout,
and has even failed to pay dividends in the last two quarters. These troubling signs,
combined with the overall market lull in the aftermath of Hurricane Katrina, have sent
Gainesboro’s share price spiraling downward, currently off 25% from just one year ago.
So, the question remains: Can Gainesboro increase its value through its choice of
distribution policy, defined as the level of distributions, the form of distributions, and
the stability of distributions?

In this study we’ll explore key concepts in managing firm equity and how it pertains to
Gainesboro Tools. We will systematically explore payout policy goals, distribution
theories, dividend and stock repurchase policies, and how these concepts may affect
investor and firm wealth. We’ll then use and consume this information to formulate a
payout policy recommendation for Gainesboro management.

Fowler/Jamison Page 2

Case Dilemma

(When) asked if the company planned to start paying a dividend or initiate a stock
buyback program, "At this time, we have no plans to do either. We don't think it's our
job to manage our shareholders. It's our job as the management team to manage the
company, to manage it through when the stock price is going up and to manage it when
the stock price is going down.”
Steven Jobs (Hillis, “Apple Plans no Dividend or buyback”)

“Dividends are real money. That's the hallmark of a blue chip stock. If a company doesn't
pay a dividend, it's a speculation.”
Geraldine Weiss (Sullivan, “Dividend Stocks Pay Off”)

These opinions are indicative of the dilemma facing Gainesboro management, who in
their decisions must not only consider their internal preferences for the use of free cash
flow, they must also consider investors’ preferences. Their decisions, up this point, have
led them to a corporate repositioning as a high‐growth firm in the industrial software
and advanced‐technology industry, maintaining a small element (25% of revenue) of
their old identity in a mature manufacturing market. In pursuit of this new course, two
expensive reorganizations, slowing sales in their traditional line, and low margins in their
new line had left them with extraordinary losses and no excess cash on hand.
Regardless, management wanted and expected to grow at a 15% compound rate
annually in anticipation of reaching $2 billion in sales by 2011 and was considering
revamping the company brand to project their new line of business. Gainesboro had
paid for a new corporate identity, but the market was confused as to what that image
was: dependable income stock, or, opportunistic high‐growth stock?

Management is considering the following payout options: (a) a zero‐dividend payout,
opting not to pay dividends to shareholders, (b) a 40% dividend ratio, translating to an
approximate $.20 per share per quarter cash distribution, (c) a residual dividend payout,
where dividends would be paid only if leftover cash remained after new investments
and capital projects were funded, and (d) a stock repurchase program, where funds
would be used to repurchase stock instead of paying out a dividend.

Before a recommendation can be made, relevant financial concepts and market payout
theories should be explored.


Concepts of Payout Policy

The goal of an earnings payout policy is to distribute the firm’s earnings to the owner‐
shareholders of the company while maximizing both firm and shareholder wealth. A
firm generally has three primary options in distributing excess cash flows generated
from internal operations: pay a cash dividend to investors, repurchase a portion of their
outstanding stock, and retain earnings. The first option to be considered is retention.
Retained excess cash can later be used to invest in future growth opportunities for the
firm. With reinvestments, a firm may yield a greater return than investors could
otherwise generate in an alternate investment of similar risk. This is the strategy used
by the majority of growth firms as an attempt to compete and gain market share away
from competitors. After growth opportunities and capital projects are considered, the
firm could pay out a portion or all remaining excess cash. We’ll explore the following
relevant theories in order to adequately understand the reasons and consequences of
doing so.

Dividends and Dividend Theories
A dividend is defined as a portion of corporate earnings paid out to shareholders. The
relevance of dividends has been debated throughout academia and the corporate world
but no conclusive evidence has been presented to name any one theory dominant. For
the purpose of this paper we will discuss three: dividend irrelevance, bird‐in‐hand, and
tax preference theory.

The dividend irrelevance theorem, championed by Miller and Modigiliani, states that
the value of a firm is determined only by the income produced by its assets, not by how
this income is distributed. If an investor desires a cash payment but the firm does not
pay dividends, he has the ability to “create” a dividend by selling shares of stock. On the
other hand, if an investor does not desire regular income from a dividend‐paying firm,
he has the ability to use his dividend to purchase additional shares of the firm. In
simplifying the theory, Miller and Modigiliani ignore taxes consequences and
transaction fees and presuppose 100% free cash flow payout, gaping assumptions which
are sharply criticized by many and still argued over today.

Another theory, the clientele effect, is important to discuss with the dividend
irrelevance theorem. It explains that different groups of investors (called clientele)
prefer different payout methods. Retirees, pension funds, and endowments generally
prefer cash payouts because they have low or no tax liability and seek to avoid
unnecessary transaction costs. Conversely, peak‐earning investors in high tax brackets
would prefer to defer tax liability by opting for increased value in stock price instead of
cash distributions. The clientele effect states that no matter the policy a company
adopts, the stock will attract investors and one clientele is a good as another.
Additionally, it highlights that frequent changes to payout policy is unattractive to
investors due to excessive brokerage costs, unnecessary tax liability, and a potential
shortage of investors who prefer the new policy.

The bird‐in‐hand theory suggests that dividends are preferred over capital gains. This
theory states that stock price is positively affected by dividend payout because investors
are more confident in reliable dividends than they are of variable capital gains
potentially achieved from retained earnings. Opponents argue that if this were true,
high‐dividend stocks would consistently trade above their zero‐dividend peers, which
studies have shown is not the case.

The tax preference theory states that investors prefer capital gains over dividends. It
suggests that some investors may avoid dividends because of the annual tax liability.
Capital gains tax, however, can be avoided and deferred by simply not selling. The time
value effects of deferring taxes also may magnify the preference for capital gains. In
theory, these tax advantages would compel investors to pay more for a low‐payout
company than a similar high‐payout company.

Stock Repurchases
A stock repurchase occurs when a firm buys back its shares in the open market or in a
tender transaction. An open market transaction is executed after the firm announces its
intent to buyback a certain amount of shares or pre‐set amount of dollars in the open
market. The firm makes opportunistic buys when it believes that its stock is
undervalued in the market. A tender transaction is when the firm buys back shares at a
premium to the current market price. The major advantages of a repurchase program
include boosting earnings per share (EPS), adjusting capital structure, and signaling
confidence in future earnings potential. Repurchases are also viewed as being more
flexible than dividends, since a certain element of timing can be employed.
Repurchasing has become so prevalent in today’s market that financial experts have
pronounced repurchases as the dominant form of payout. Douglas Skinner, of the
University of Chicago, goes so far as to proclaim dividend‐only firms as extinct, (Skinner).
Repurchases are increasingly used in place of dividends because of its flexibility and
signals of self‐confidence, even for firms that continue to pay dividends.

Signaling
When it is decided that a company should initiate or change a payout policy, potential
consequences of the announcement should be considered first. Changes in payout
policy implicitly reveal, or signal, information content regarding earnings potential to
the market, and the market will use this new information to make decisions about the
firm. Empirical studies show that on average, firms that reduce dividends have had poor
earnings in the quarters leading up to the cut, but most have actually improved earnings
in subsequent years, (Bernartzi, Michaely, Thaley). This usually occurs because the
excess cash can instead be used for more constructive purposes, like paying down debt,
making short‐term investments, and entering other opportunities. Studies also show
that firms that increase dividends are less likely than dividend‐idle firms to experience a
drop in future earnings, and, that stock price tends to fall when payout programs are cut
but stock prices do not always rise when payouts are elevated. Knowing this, the
market typically expects equivalent activity after similar announcements.

Payout Evolution
Another noteworthy observation is that firms today, regardless of their profitability and
other characteristics, have become less likely to pay dividends. The proportion of firms
paying cash dividends fell from 66.5% in 1978 to 20.8% in 1999. More publicly traded
firms than ever before are small businesses with low profitability but strong growth
opportunities. It is also because firms have a lower propensity to pay dividends since
the common presumption is that various factors make dividends less valuable than
capital gains, (Fama). In a recent survey of 384 financial executives, maintaining
dividend level (for dividend‐paying firms) is found to be equally as important as other
investment decisions. For the executives, projecting stability of earnings is important,
but they felt the link between earnings and dividends has waned. Many now favor
repurchases because of its built‐in flexibility and its effects to earnings per share. (Brav,
Graham, Harvey, Michaely).

Recommendation

Payout policies vary greatly from one industry to another. Mature markets tend to pay
high dividends because there are few opportunities for growth. For example, the
utilities sector is strictly regulated, limiting acquisitions and innovations, therefore
earnings may be distributed in large quantities with minimal need for savings. The
technology sector, on the other hand, tends to pay no dividends because there are
considerable opportunities for growth, including continual research and development,
market share initiatives, and acquisitions. A firm in an industry with abundant growth
prospects may prefer to have excess cash on hand to exploit the many money‐making
opportunities, however, the optimal payout policy for each individual firm will vary.
Gainesboro historically employed high‐dividends when its core business was in mature
industries. The machine tools and manufacturing industry offered few opportunities for
growth. Gainesboro’s new initiatives take place in the software and high‐technology
industry, an industry ripe with investment and growth opportunities, both domestic and
international. Gainesboro’s management engaged in these exploits with high‐dividend
payouts and has been punished for it with extraordinary losses. It is with this reason
that we recommend Gainesboro introduce a zero‐dividend policy.

We feel a zero‐dividend policy coupled with a residual stock repurchase program is the
optimal payout policy for Gainesboro. A clear, stable zero‐dividend policy effectively
communicates that Gainesboro is aggressively pursuing opportunities for growth in a
rapidly expanding industry. A residual stock repurchase program is recommended
because of its flexibility and signaling effects. Announcing such an initiative would
publicly communicate that the company has full faith and confidence in future earnings.
Repurchasing shares would serve to inflate EPS, and, although no assurances can be
made, may influence the share price upward.

Income‐seeks may be un‐attracted to a zero‐dividend policy but this investor group has
already been actively divesting. The firm’s traditional clientele has been turning over
since the initial dividend cut in 2004, a 30% decrease as seen in exhibit 4. Growth
investors, upon hearing that Gainesboro will reinvest in itself, expand domestically, and
pursue international prospects, should be re‐attracted to the stock, as suggested by the
clientele effect.

None of Gainesboro’s peers in the industrial high‐tech software industry pay dividends,
(Autodesk, with a low 6% payout, being the only exception), as seen in exhibit 6.
Identified also in exhibit 6 are Gainesboro’s peers in the electrical‐equipment
manufacturing industry. Its peers in this industry trade with a P/E ratio in the 16‐17
range, regardless of payout ratio. Note that both Hubbell and Thomas & Betts trade at
17.6 P/E even though Hubbell pays dividends of 52% of net income and Thomas & Betts
do not pay dividends at all. It seems either each firm has found dependable clientele
investors or payout form is irrelevant to investors in this industry.

Gainesboro should also move forward with re‐branding. The new name, Gainesboro
Advanced Systems International, more accurately represents their products and their
business, will help to project their growth potential in the advanced systems industry. It
will also assist in the attraction of growth investor clientele in the high‐growth software
industry.

Gainesboro’s new image and new payout policy will position them for success in their
new industry.

Cited Works and Recommended Readings

Benartzi, Shlomo. Michaely, Roni. Thaler, Richard. 1997. “Do changes in dividends signal the
future or the past?”. The Journal of Finance. Vol. 52, No. 3, pg 1007‐1034.

Brav, Alon. Graham, John R.. Harvey, Campbell R.. Michaely, Roni. 2005. “Payout policy in the
21st century.” Journal of Financial Economics. Vol 77, pg 483‐527.

Brigham, Eugene F.. Ehrhardt, Michael C.. “Chapter 18. Distributions to Shareholders: Dividends
and Repurchases.” Financial Management: Theory and Practice, 11th Edition. 2005

Canina, Linda. 1999. “The market’s perception of the information conveyed by dividend
announcements.” Journal of Multinational Financial Management. Vol 9, pg 1‐13.

Chen, Chung. Wu, Chunchi. 1999. “The dynamics of dividends, earnings and prices: evidence and
implications for dividend smoothing and signaling.” Journal of Empirical Finance. Vol 6,
pg 29‐58.

DeAngelo, Harry. DeAngelo, Linda. 2005. “The irrelevance of the MM dividend irrelevance
theorem.” Journal of Financial Economics. Vol. 79, pg 293‐315.

DeAngelo, Harry. DeAngelo, Linda. 2008. “Reply to: dividend policy: reconciling DD with MM.”
Journal of Financial Economics. Vol 87, pg532‐533.

Fama, Eugene. French, Kenneth R.. 2000. “Disappearing dividends: changing firm characteristics
or lower propensity to pay?”. Journal of Financial Economics. Vol 60, pg 3‐43.

Handley, John C. 2007. “Dividend policy: reconciling DD with MM”. Journal of Financial
Economics. Vol. 87, pg 528‐531.

Hillis, Scott. “Apple Plans no Dividend or Buyback.” Reuters. 2008 March 3rd.
Http://news.yahoo.com/s/nm/20080304/bs_nm/apple_dc_2. Accessed 2008 March
8th.

Miller, Merton H.. Modigliani, Franco. 1961. “Dividend Policy, Growth, and the Valuation of
Shares”. Journal of Business. Vol. 34, No. 4, pg 411‐433.

Skinner, Douglas. 2008. “The evolving relation between earnings, dividends, and stock
repurchases.” Journal of Financial Economics.

Sullivan, Missy. “Dividend Stocks Pay Off.” Forbes. 2002 February 12th.
http://www.forbes.com/2002/02/12/0212adviser.html. Accessed 2008 March 8th.


Gainesboro Case Analysis

Încărcat de

Informații document

Descriere originală:

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Gainesboro Case Analysis

Încărcat de

Drepturi de autor:

Formate disponibile

S-ar putea să vă placă și