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 firms 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 Gainesboros 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?

How might Gainesboros 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?

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 Gainesboros 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

15% Growth

20% Dividend
10% Growth

15% Growth

30% Dividend
10% Growth

15% Growth

40% Dividend
10% Growth

15% Growth

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 Gainesboros 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 retirees (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 CFs are not positive until post 2011
With realistic growth rate of 10% - CFs 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 creditors 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 Purposes
o 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 overvalued
o 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