UVA-F-1489TN

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.

The general problem in this case is modeled upon a much older case by Robert F. Vandell and Pearson Hunt, which
has been out of print for a number of years. It was believed that students today would benefit by learning from a
problem like that, but with a broader set of policy issues cast in a contemporary setting. Despite numerous
differences in form and substance between the earlier case and this, the debt to Vandell and Hunt remains large.
Vandell was a gracious colleague and mentor to the authors, who hope this work is a respectful memorial to him.
Vandell and Hunt produced no teaching note for their case. Our understanding of the Vandell–Hunt case was
assisted greatly by notes and comments from our colleague, Professor William W. Sihler, who edited the older case
and reviewed this one. The original version of this case was prepared by Casey Opitz under the direction of Robert
F. Bruner. This teaching note was written by Robert F. Bruner with the assistance of Sean D. Carr. Copyright ©
2005 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order
copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced,
stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic,
mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.
 -2- UVA-F-1489TN

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- UVA-F-1489TN

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?
 -4- UVA-F-1489TN

The data can be interpreted to support either view. The point is to show that simple
extrapolations from stock market data are untrustworthy, largely because of econometric
problems associated with size and omitted variables (see the Black and Scholes article).4
7. What should Swenson recommend?
Students must synthesize a course of action from the many facts and considerations
raised. The instructor may choose to stimulate the discussion by using an organizing
framework such as FRICTO (flexibility, risk, income, control, timing, and other) on the
dividend and share repurchase issues. The image advertising and name change issue will
be recognized as another manifestation of the firm’s positioning in the capital markets,
and the need to give effective signals.

The class discussion can end with the students voting on the alternatives, followed by a
summary of key points. Exhibit TN1 and Exhibit TN2 contain two short technical notes on
dividend policy, which the instructor may either use as the foundation for closing comments or
distribute directly to the students after the case discussion.

Case Analysis

Gainesboro’s asset needs

The company’s investment spending and financing requirements are

Discussion
driven by ambitious growth goals (a 15% annual target is discussed in the case), question 2
which are to be achieved by a repositioning of the firm—away from its
traditional tools-and-molds business and beyond its CAD/CAM business into a
new line of products integrating hardware and software—to provide complete manufacturing
systems. CAD/CAM commanded 45% of total sales ($340.5 million) in 2004 and is expected to
grow to three-quarters of sales ($1,509.5 million) by 2011, which implies a 24% annual rate of
growth in this business segment over the subsequent seven years. In addition, international sales
are expected to grow by 37% compounded over the subsequent seven years. 5 By contrast, the
presses-and-molds segment will grow at about 2.7% annually in nominal terms, which implies a
negative real rate of growth in what constitutes the bulk of Gainesboro’s current business. 6 In
short, the company’s asset needs are driven primarily by a shift in the company’s strategic focus.

4
Fisher Black and Myron Scholes, “The Effects of Dividend Yield and Dividend Policy on Common-Stock
Prices and Returns,” Journal of Financial Economics 1 (1974): 1–22.
5
International sales accounted for 15% ($113.5 million) in 2004. They are expected to account for one-half of
all sales by 2011 ($1,006.4 million).
6
Presses and molds accounted for 55% of sales ($416.2 million) in 2004. By 2011, this segment will account
for about one-quarter of sales ($503.2 million). The implied compound annual growth rate of 2.7% is below the
projected 3-month Treasury bill rates given in case Exhibit 3, suggesting that the real rate of growth in this segment
is below zero.
 -5- UVA-F-1489TN

Financial implications of payout alternatives

The instructor can guide the students through the financial implications of Discussion
various dividend-payout levels either in abbreviated form (for one class period) question 3
or in detail (for two classes). The abbreviated approach uses the total cash flow
figures (that is, for 2005–2011) found in the right-hand column of case Exhibit 8. In essence, the
approach uses the basic sources-and-uses of funds identity:

Asset change = New debt + (Profits − Dividends)

With asset additions fixed largely by the firm’s competitive strategy, and with profits
determined largely by the firm’s operating strategy and the environment, the remaining large-
decision variables are changes in debt and dividend payout. Even additions to debt are
constrained, however, by the firm’s maximum leverage target, a debt/equity ratio of 0.40. This
framework can be spelled out for the students to help them envision the financial context.

Exhibit TN3 presents an analysis of the effect of payout on unused debt capacity based
on the projection in case Exhibit 8. The top panel summarizes the firm’s investment program
over the forecast period, as well as the financing provided by internal sources. The bottom panel
summarizes the effect of higher payouts on the firm’s financing and unused debt capacity. The
principal insight this analysis yields is that the firm’s unused debt capacity disappears rapidly,
and maximum leverage is achieved as the payout increases. Going from a 20% to a 40%
dividend payout (an increase in cash flow to shareholders of $95.6 million),7 the company
consumes $134 million in unused debt capacity. Evidently, a multiplier relationship exists
between payout and unused debt capacity—every dollar of dividends paid consumes about
$1.408 of debt capacity. The multiplier exists because a dollar must be borrowed to replace each
dollar of equity paid out in dividends, and each dollar of equity lost sacrifices $0.40 of debt
capacity that it would have otherwise carried.

Whereas the abbreviated approach to analyzing the implications of various dividend-

payout levels considers total 2005 to 2011 cash flows, the detailed approach considers the pattern
of the individual annual cash flows. Exhibit TN4 reveals that, although the debt/equity ratio
associated with the 40% payout policy is well under the maximum of 40 in 2011, the maximum
is breached in the preceding years. The graph suggests that a payout policy of 30% is about the
maximum that does not breach the debt/equity maximum.

Exhibit TN5 and Exhibit TN6 reveal some of the financial reporting and valuation
implications of alternative dividend policies. Those exhibits use a simple dividend valuation

7
The change in cash flow to shareholders is equal to the difference between dividends paid under the 40%
policy ($215.1 million) and the dividends ($107.6 million) and stock buy-back ($11.9 million) under the 20%
policy.
8
Unused debt capacity of $134 million ÷ additional dividends paid of $95 million results in a ratio of about 1.4.
 -6- UVA-F-1489TN

approach and assume a terminal value estimated as a multiple of earnings. The analysis is
unscientific, as the case does not contain the information with which to estimate a discount rate
based on the capital asset pricing model (CAPM).9 The discounted cash flow (DCF) values show
that the differences in firm values are not that large and that the dividend policy choice in this
case has little effect on value. This conclusion is consistent with the Miller-Modigliani dividend-
irrelevance theorem.

Regarding the financial-reporting effects of the policy choices, one sees that earnings per
share (EPS on line 30 in Exhibits TN5 and TN6) and the implied stock price (line 31) grow
more slowly at a 40% payout policy, because of the greater interest expense associated with
higher leverage (see the cumulative source on line 22). Return on average equity (unused debt
capacity on line 28) rises with higher leverage, however, as the equity base contracts. The
instructor could use insights such as those to stimulate a discussion of the signaling
consequences of the alternative policies, and whether investors even care about performance
measures, such as EPS and return on equity (ROE).10

Risk assessment

Neither the abbreviated nor detailed forecasts consider adverse deviations

Discussion
from the plan. Case Exhibit 8 assumes no cyclical downturn over the seven-year question 4
forecast period. Moreover, the model assumes that net margin doubles to 5% and
then increases to 8%. The company may be able to rationalize those optimistic
assumptions on the basis of its restructuring and the growth of the Artificial Workforce, but such
a material discontinuity in the firm’s performance will warrant careful scrutiny. Moreover,
continued growth may require new product development after 2006, which may incur significant
research-and-development (R&D) expenses and reduce net margin.

Students will point out that, so far, the company’s restructuring strategy is associated
with losses (in 2002 and 2004) rather than gains. Although restructuring appears to have been
necessary, the credibility of the forecasts depends on the assessment of management’s ability to
begin harvesting potential profits. Plainly, the Artificial Workforce has the competitive
advantage at the moment, but the volatility of the firm’s performance in the current period is
significant: The ratio of the cost of goods sold to sales rose from 61.5% in 2003 to 65.9% in
2004. Meanwhile, the ratio of selling, general, and administrative expenses to sales is projected
to fall from 30.5% in 2004 to 24.3% in 2005. Admittedly, the restructuring accounts for some of
this volatility, but the case suggests several sources of volatility that are external to the company:

9
A discount rate of 12% is used for illustrative purposes. Presumably, the required ROE would vary with the
leverage of the firm.
10
Those measures are subject to accounting manipulation and are therefore unreliable. Many operating
executives believe, however, that such measures can still retain some influence over the type of equity investors that
a firm attracts.
 -7- UVA-F-1489TN

economic recession, currency, new-competitor market entry, new product mishaps, cost
overruns, and unexpected acquisition opportunities.

A brief survey of risks invites students to perform a sensitivity analysis of the firm’s
debt/equity ratio under a reasonable downside scenario. Students should be encouraged to
exercise the associated computer spreadsheet model, making modifications as they see fit.
Exhibit TN7 presents a forecast of financial results, assuming a net margin that is smaller than
the preceding forecasts by 1% and sales growth at 12% rather than 15%. This exhibit also
illustrates the implications of a residual dividend policy, which is to say the payment of a
dividend only if the firm can afford it and if the payment will not cause the firm to violate its
maximum debt ratios. The exhibit reveals that, in this adverse scenario, although a dividend
payment would be made in 2005, none would be made in the two years that follow. Thereafter,
the dividend payout would rise. The general insight remains that Gainesboro’s unused debt
capacity is relatively fragile and easily exhausted.

The stock-buyback decision

The decision on whether to buy back stock should be that, if the intrinsic Discussion
value of Gainesboro is greater than its current share price, the shares should be question 5
repurchased. The case does not provide the information needed to make free cash
flow projections, but one can work around the problem by making some assumptions. The DCF
calculation presented in Exhibit TN8 uses net income as a proxy for operating income,11 and
assumes a weighted-average cost of capital (WACC) of 10%, and a terminal value growth factor
of 3.5%. The equity value per share comes out to $35.22, representing a 59% premium over the
current share price. Based on that calculation, Gainesboro should repurchase its shares.

Doing so, however, will not resolve Gainesboro’s dividend/financing problem. Buying
back shares would further reduce the resources available for a dividend payout. Also, a stock
buyback may be inconsistent with the message that Gainesboro is trying to convey, which is that
it is a growth company. In a perfectly efficient market, it should not matter how investors got
their money back (for example, through dividends or share repurchases), but in inefficient
markets, the role of dividends and buybacks as signaling mechanisms cannot be disregarded. In
Gainesboro’s case, we seem to have the case of an inefficient market; the case suggests that
information asymmetries exist between company insiders and the stock market.

Clientele and signaling considerations

The profile of Gainesboro’s equity owners may influence the choice of Discussion
dividend policy. Stephen Gaines, the board chair and scion of the founders’ question 6
families and management (who collectively own about 30% of the stock), seeks

11
This violates the rule that free cash flows should reflect prefinancing cash flows. We are not given any
operating income assumptions.
 -8- UVA-F-1489TN

to maximize growth in the market value of the company’s stock over time. This goal invites
students to analyze the impact of the dividend policy on valuation. Nevertheless, some students
might point out that, as Gaines and Scarboro’s population of diverse and disinterested heirs
grows, the demand for current income might rise. This naturally raises the question: Who owns
the firm? The stockholder data in case Exhibit 4 show a marked drift over the past 10 years,
moving away from long-term individual investors and toward short-term traders; and away from
growth-oriented institutional investors and toward value investors. At least a quarter of the firm’s
shares are in the hands of investors who are looking for a turnaround in the not too distant
future.12 This lends urgency to the dividend and signaling question.

The case indicates that the board committed itself to resuming a dividend as early as
possible—“ideally in the year 2005.” The board’s letter charges this dividend decision with some
heavy signaling implications: because the board previously stated a desire to pay dividends, if it
now declares no dividend, investors are bound to interpret the declaration as an indication of
adversity. One is reminded of the story, “Silver Blaze,” written by Sir Arthur Conan Doyle
featuring the famous protagonist Sherlock Holmes, in which Dr. Watson asks where to look for a
clue:

“To the curious incident of the dog in the nighttime,” says Holmes.
“The dog did nothing in the nighttime,” Watson answers.
“That was the curious incident,” remarked Sherlock Holmes.13

A failure to signal a recovery might have an adverse impact on share price. In this context, a
dividend—almost any dividend—might indicate to investors that the firm is prospering more or
less according to plan.

Astute students will observe that a subtler signaling problem occurs in the case: What
kind of firm does Gainesboro want to signal that it is? Case Exhibit 6 shows that CAD/CAM
equipment and software companies pay low or no dividends, in contrast to electrical machinery
manufacturers, who pay out one-quarter to as much as half of their earnings. One can argue that,
as a result of its restructuring, Gainesboro is making a transition from the latter to the former. If
so, the issue then becomes how to tell investors.

The article by Asquith and Mullins14 suggests that the most credible signal about
corporate prospects is cash, in the form of either dividends or capital gains. Until the Artificial
Workforce product line begins to deliver significant flows of cash, the share price is not likely to
respond significantly. In addition, any decline in cash flow, caused by the risks listed earlier,

12
Those “turnaround” investors probably include the value-oriented institutional investors (13% of shares) and
the short-term, trading-oriented individual investors (13% of shares).
13
The New Annotated Sherlock Holmes, Sir Arthur Conan Doyle (New York: W.W. Norton, 2005), 557.
14
Paul Asquith and David W. Mullins Jr., “Signaling with Dividends, Stock Repurchases, and Equity Issues,”
Financial Management (autumn 1986): 27–44.
 -9- UVA-F-1489TN

would worsen the anticipated gain in share price. By implication, the Asquith–Mullins work
would cast doubt on corporate-image advertising. If cash dividends are what matters, then
spending on advertising and a name change might be wasted.

Stock prices and dividends

Some of the advocates of the high-dividend payout suggest that high stock prices are
associated with high payouts. Students may attempt to prove that point by abstracting from the
evidence in case Exhibits 6 and 7. As we know from academic research (for example, Friend and
Puckett),15 proving the relationship of stock prices to dividend payouts in a scientific way is
extremely difficult. In simpler terms, the reason is because the price/earnings (P/E) ratios are
probably associated with many factors that may be represented by dividend payout in a
regression model. The most important of those factors is the firm’s investment strategy; Miller
and Modigliani’s16 dividend-irrelevance theorem makes the point that the firm’s investments—
not the dividends it pays—determine the stock prices. One can just as easily derive evidence of
this assertion from case Exhibit 7. The sample of zero-payout companies has a higher average
expected return on capital (24.9%) than the sample of high-payout companies (average expected
return of 9.4%); one may conclude that zero-payout companies have higher returns than the
high-payout companies and that investors would rather reinvest in zero-payout companies than
receive a cash payout and be forced to redeploy the capital to lower-yielding investments.

Decision

The decision for students is whether Gainesboro should buy back Discussion
stock or declare a dividend in the third quarter (although, for practical question 1 and
purposes, students will find themselves deciding for all of 2005). As the closing vote
analysis so far suggests, the case draws students into a tug-of-war between
financial considerations, which tend to reject dividends and buybacks at least in the near term,
and signaling considerations, which call for the resumption of dividends at some level, however,
small. Students will tend to cluster around the three proposed policies: (1) zero payout, (2) low
payout (1% to 10%), and (3) a residual payout scheme calling for dividends when cash is
available.

The arguments in favor of zero payout are: (1) the firm is making the transition into the
CAD/CAM industry, where zero payout is the mode; (2) the company should not ignore the
financial statements and act like a blue-chip firm—Gainesboro’s risks are large enough without

15
Irwin Friend and M. Puckett, “Dividends and Stock Prices,” American Economic Review 54 (September
1964): 656–682.
16
Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of
Business 34 (October 1961): 411–433.
 -10- UVA-F-1489TN

compounding them by disgorging cash; and (3) the signaling damage already occurred when the
directors suspended the dividend in 2005.

The arguments in favor of a low payout are usually based on optimism about the firm’s
prospects and on beliefs that Gainesboro has sufficient debt capacity, that Gainesboro is not
exactly a CAD/CAM firm, and that any dividend that does not restrict growth will enhance share
prices. Usually, the signaling argument is most significant for the proponents of this policy.

The residual policy is a convenient alternative, although it resolves none of the thorny
policy issues in the case. A residual dividend policy is bound to create significant signaling
problems as the firm’s dividend waxes and wanes through each economic cycle.

The question of the image advertising and corporate name change will entice the naive
student as a relatively cheap solution to the signaling problem. The instructor should challenge
such thinking. Signaling research suggests that effective signals are both unambiguous and
costly. The advertising and name change, costly as they may be, hardly qualify as unambiguous.
On the other hand, seasoned investor relations professionals believe that advertising and name
changes can be effective in alerting the capital markets to major corporate changes when
integrated with other signaling devices such as dividends, capital structure, and investment
announcements. The whole point of such campaigns should be to gain the attention of the “lead
steer” opinion leaders.

Overall, inexperienced students tend to dismiss the signaling considerations in this case
quite readily. On the other hand, senior executives and seasoned financial executives view
signaling quite seriously. If the class votes to buy back stock or to declare no dividend in 2005,
asking some of the students to dictate a letter to shareholders explaining the board’s decision
may be useful. The difficult issues of credibility will emerge in class with a critique of this letter.

If the class does vote to declare a dividend payout, the instructor can challenge the
students to identify the operating policies they gambled on to make their decision. The
underlying question: If adversity strikes, what will the class sacrifice first: debt, or dividend
policies?

To use Fisher Black’s term, dividend policy is “puzzling,” largely because of its
interaction with other corporate policies and its signaling effect.17 Decisions about the firm’s
dividend policy may be the best way to illustrate the importance of managers’ judgments in
corporate finance. However the class votes, one of the teaching points is that managers are paid
to make difficult, even high-stakes policy choices on the basis of incomplete information and
uncertain prospects.

17
Fisher Black, “The Dividend Puzzle,” Journal of Portfolio Management (winter 1976): 5–8.
 -11- UVA-F-1489TN

Exhibit TN1
GAINESBORO MACHINE TOOLS CORPORATION
The Dividend Decision and Financing Policy

The dividend decision is necessarily part of the financing policy of the firm. The dividend
payout chosen may affect the creditworthiness of the firm and hence the costs of debt and equity;
if the cost of capital changes, so may the value of the firm. Unfortunately, one cannot determine
whether the change in value will be positive or negative without knowing more about the
optimality of the firm’s debt policy. The link between debt and dividend policies has received
little attention in academic circles, largely because of its complexity, but it remains an important
issue for chief financial officers and their advisors. The Gainesboro case illustrates the impact of
dividend payout on creditworthiness.

Dividend payout has an unusual multiplier effect on financial reserves. Table TN1 varies
the total 2005–11 sources-and-uses of funds information given in case Exhibit 8, according to
different dividend-payout levels.
 -12- UVA-F-1489TN

Exhibit TN1 (continued)

Table TN1.

Targeted Dividend Payout Remarks

0% 20% 40% 50%
Net profit $537.8 $537.8 $537.8 $537.8
Less dividends - 107.6 215.1 268.9
Earnings retained 537.8 430.2 322.7 268.9
New debt (stock buyback) (119.3) (11.9) 95.5 149.2
Depreciation 252.0 252.0 252.0 252.0
Increase in assets 670.4 670.3 670.2 670.1

Initial debt (2004) 80.3 80.3 80.3 80.3

Zero if (retained earnings + depreciation)

>= increase in assets; otherwise the
Change in debt - - 95.5 149.2
difference between (retained earnings +
depreciation) and (increase in assets)

Ending debt (2011) 80.3 80.3 175.8 229.5

Initial equity (2004) 282.5 282.5 282.5 282.5

Earnings retained 537.8 430.2 322.7 268.9
Zero if (retained earnings + depreciation)
<= increase in assets; otherwise the
Stock buyback (119.3) (11.9) - -
difference between (retained earnings +
depreciation) and (increase in assets)

Ending equity (2007) 701.0 700.8 605.2 551.4

Total capital 781.3 781.1 781.0 780.9

Debt / total capital 10.3% 10.3% 22.5% 29.4%

Debt / equity 11.5% 11.5% 29.0% 41.6%

Debt capacity 280.4 280.3 242.1 220.6

(@ 0.4 = max debt / equity)
Debt capacity used 80.3 80.3 175.8 229.5
Unused debt capacity 200.1 200.1 66.3 (8.9)
Ratio of debt capacity used for
Incremental debt / incremental dividends
incremental payments to
and stock buybacks
shareholders 1.40 1.40
 -13- UVA-F-1489TN

Exhibit TN1 (continued)

As Table TN1 reveals, one dollar of dividends paid consumes $1.40 in unused debt
capacity. At first glance, this result seems surprising—under the sources-and-uses framework,
one dollar of dividend is financed with only one dollar of borrowing. The sources-and-uses
reasoning, however, ignores the erosion in the equity base: A dollar paid out of equity also
eliminates $0.40 of debt that the dollar could have carried. Thus, a multiplier effect exists
between dividends and unused debt capacity, whenever a firm borrows to pay dividends.

Choosing a dividend payout will affect the probability that the firm will breach its
maximum target leverage. Figure TN1 traces the debt/equity ratios associated with Gainesboro’s
dividend-payout ratios.

Figure TN1.

Debt/Equity Ratios by Dividend Payout

50.0%
Payout 0%
40.0%
Payout 10%
Debt/equity ratio

30.0%
Payout 20%
20.0%
Payout 30%
10.0%
Payout 40%
0.0%

-10.0% Maximum
debt/equity
2005 2006 2007 2008 2009 2010 2011
Year

Plainly, the 40% dividend-payout ratio violates Gainesboro’s maximum debt/equity ratio of
40%.

The conclusion is that, because the dividend policy affects the firm’s creditworthiness,
senior managers should weigh the financial side effects of their payout decisions, along with the
signaling, segmentation, and investment effects, to arrive at their final decision for the dividend
policy.
 -14- UVA-F-1489TN

Exhibit TN2
GAINESBORO MACHINE TOOLS CORPORATION
Setting Debt and Dividend-Payout Targets

The Gainesboro Machine Tools Corporation case well illustrates the challenge of setting
the two most obvious components of financial policy: target payout and debt capitalization. The
policies are linked with the firm’s growth target, as shown in the self-sustainable growth model:

gss = (P/S × S/A × A/E)(1 − DPO)

where:

gss is the self-sustainable growth rate

P is net income
S is sales
A is assets
E is equity
DPO is the dividend-payout ratio

This model describes the rate at which a firm can grow if it issues no new shares of common
stock, which describes the behavior or circumstances of virtually all firms. The model illustrates
that the financial policies of a firm are a closed system: Growth rate, dividend payout, and debt
targets are interdependent. The model offers the key insight that no financial policy can be set
without reference to the others. As Gainesboro shows, a high dividend payout affects the firm’s
ability to achieve growth and capitalization targets and vice versa. Myopic policy—failing to
manage the link among the financial targets—will result in the failure to meet financial targets.

Setting Debt-Capitalization Targets

Finance theory is split on whether gains are created by optimizing the mix of debt and
equity of the firm. Practitioners and many academicians, however, believe that debt optima exist
and devote great effort to choosing the firm’s debt-capitalization targets. Several classic
competing considerations influence the choice of debt targets:

1. Exploit debt-tax shields. Modigliani and Miller’s theorem implies that in the world of
taxes, debt financing creates value.1 Later, Miller theorized that when personal taxes are
accounted for, the leverage choices of the firm might not create value. So far, the bulk of
the empirical evidence suggests that leverage choices do affect value.
2. Reduce costs of financial distress and bankruptcy. Modigliani and Miller’s theory naively
implied that firms should lever up to 99% of capital. Virtually no firms do this. Beyond
 -15- UVA-F-1489TN

Exhibit TN2 (continued)

some prudent level of debt, the cost of capital becomes very high because investors
recognize that the firm has a greater probability of suffering financial distress and
bankruptcy. The critical question then becomes: What is “prudent”? In practice, two
classic benchmarks are used:
a. Industry-average debt/capital: Many firms lever to the degree practiced by peers, but
this policy is not very sensible. Industry averages ignore differences in accounting
policies, strategies, and earnings outlooks. Ideally, prudence is defined in firm-
specific terms. In addition, capitalization ratios ignore the crucial fact that a firm goes
bankrupt because it runs out of cash, not because it has a high debt/capital ratio.
b. Firm-specific debt service: More firms are setting debt targets based on the forecasted
ability to cover principal and interest payments with earnings before interest and taxes
(EBIT). This practice requires forecasting the annual probability distribution of EBIT
and setting the debt-capitalization level, so that the probability of covering debt
service is consistent with management’s strategy and risk tolerance.
3. Maintain a reserve against unforeseen adversities or opportunities. Many firms keep their
cash balances and lines of unused bank credit larger than may seem necessary, because
managers want to be able to respond to sudden demands on the firm ’s financial resources
caused, for example, by a price war, a large product recall, or an opportunity to buy the
toughest competitor. Academicians have no scientific advice about how large those
reserves should be.
4. Maintain future access to capital. In difficult economic times, less creditworthy
borrowers may be shut out from the capital markets and, thus, unable to obtain funds. In
the United States, “less creditworthy” refers to the companies whose debt ratings are less
than investment grade (which is to say, less than BBB2 or Baa3). Accordingly, many firms
set debt targets in such a way as to at least maintain a creditworthy (or investment grade)
debt rating.
5. Opportunistically exploit capital-market windows. Some firms’ debt policies vary across
the capital-market cycle. Those firms issue debt when interest rates are low (and issue
stock when stock prices are high); they are bargain-hunters (even though no bargains
exist in an efficient market). Opportunism does not explain how firms set targets so much
as why firms deviate from those targets.

Setting Dividend-Payout Targets

In theory, dividend policy should have no effect on the value of a firm’s shares.
Nonetheless, dividend-payout decisions absorb so much of the time of highly paid, intelligent
senior executives that dividend payout must be important economically. These are the key
considerations that emerge in payout decisions:
 -16- UVA-F-1489TN

Exhibit TN2 (continued)

1. Financing attractive investments: Miller and Modigliani’s famous dividend-irrelevance

theorem suggests that dividend policy should be set as a residual—that is, the real
question to ask is whether and how the firm can finance all its positive net present value
(NPV) investment opportunities. Under that view, dividends paid out are simply the cash
flow that remains after a firm makes attractive investments.
2. Sending signals: Executives do not want to tell the world what they foresee for their
companies, because that projection would telegraph their moves to their competitors.
Paying progressively higher dividends is one way to convey optimism about the future.
The investment community, however, forms its own expectations about the firm’s future
and dividend payments. Dividends have signaling content when they deviate from
investors’ expectations. A surprisingly high or low change in dividend payments conveys
news to investors. Cutting a dividend (even to finance an attractive investment) is
universally perceived as bad news.
3. Building a reputation: Academic research finds that dividend payments “ratchet” up: they
tend to rise or hold steady, but only fall rarely. Many companies advertise their unbroken
string of annual dividend increases. Managers believe that dividend payout builds a
reputation of investment performance.
4. Segmenting the capital market and attracting an investor clientele: If capital markets are
not homogeneous, some investors will pay more for the share of high-payout firms and
others will pay less. From that point of view, CFOs should be like consumer marketers,
aiming to position their product (for example, their shares) to the investor clientele that is
willing to pay the most. The firm’s choice of dividend payout may influence the position
of its shares. This view is provocative and not easily implemented for large public
corporations. On the other hand, this consideration is enormously important for privately
owned businesses, because it suggests that managers should listen to the owners’ needs
for cash.

Conclusion

Corporate debt and dividend policies emerge after weighing difficult trade-offs among
competing desirable ends. No algorithm or model straightforwardly dictates policies. As analysts
and managers, we confront the need to run the decision process well by ensuring that all trade-
offs surface and that all arguments are heard. Ultimately, good policies meet these three tests:

1. Do they create value?

2. Do they create a competitive advantage?
3. Do they sustain the company’s managerial vision?
 -17- UVA-F-1489TN

Exhibit TN3
GAINESBORO MACHINE TOOLS CORPORATION
Dividend Payout’s Impact on the Need for External Funds by 2011
(dollars in millions)

Targeted Dividend Payout

0% 20% 40% 50%
Net profit $537.8 $537.8 $537.8 $537.8
Less dividends - 107.6 215.1 268.9
Earnings retained 537.8 430.2 322.7 268.9
New debt (stock buyback) (119.3) (11.9) 95.5 149.2
Depreciation 252.0 252.0 252.0 252.0
Increase in assets 670.4 670.3 670.2 670.1

Initial debt (2004) 80.3 80.3 80.3 80.3

Change in debt - - 95.5 149.2

Ending debt (2011) 80.3 80.3 175.8 229.5

Initial equity (2004) 282.5 282.5 282.5 282.5

Earnings retained 537.8 430.2 322.7 268.9

Stock buyback (119.3) (11.9) - -

Ending equity (2007) 701.0 700.8 605.2 551.4

Total capital 781.3 781.1 781.0 780.9

Debt / total capital 10.3% 10.3% 22.5% 29.4%

Debt / equity 11.5% 11.5% 29.0% 41.6%

Debt capacity 280.4 280.3 242.1 220.6

(@ 0.4 = max debt / equity)
Debt capacity used 80.3 80.3 175.8 229.5
Unused debt capacity 200.1 200.1 66.3 (8.9)
Ratio of debt capacity used for
incremental payments to
shareholders 1.40 1.40
 -18- UVA-F-1489TN

Exhibit TN4
GAINESBORO MACHINE TOOLS CORPORATION
Debt/Equity Results’ Sensitivity to Variations in Payout Ratio

Dividend payout 2005 2006 2007 2008 2009 2010 2011

0% 34.6% 33.2% 27.6% 21.0% 12.2% 6.0% -5.2%
10% 35.5% 35.6% 31.7% 26.5% 18.7% 13.1% 2.2%
20% 36.4% 38.2% 36.1% 32.5% 26.0% 21.4% 10.9%
30% 37.2% 40.8% 40.8% 39.2% 34.2% 30.9% 21.2%
40% 38.1% 43.5% 45.8% 46.5% 43.6% 42.0% 33.7%
Max. D/E ratio 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%

Debt/Equity Ratios by Dividend Payout

50.0%
Payout 0%
40.0%
Payout 10%
Debt/equity ratio

30.0%
Payout 20%
20.0%
Payout 30%
10.0%
Payout 40%
0.0%
Maximum
-10.0% debt/equity
2005 2006 2007 2008 2009 2010 2011
Year

Note: Negative debt/equity ratios imply that the firm has repaid debt and carries excess cash.
 -19- UVA-F-1489TN

Exhibit TN5
GAINESBORO MACHINE TOOLS CORPORATION
Forecast of Financing Need Assuming 40% Payout1
(dollars in millions)

Common Assumptions
1 Sales growth 15.0%
2 Net income margin 2.1% 4.0% 5.0% 5.5% 6.0% 5.6% 8.0%
3 Dividend payout 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%
4 Beginning debt 80.3
5 Beginning equity 282.5
6 Shares outstanding 18.6
2
7 Price earnings ratio 24.6
8 Current market price $22.15
9 Debt/equity maximum 40.0%
10 Borrowing rate 6.0%
11 Tax rate 35.0%
Total
2005 2006 2007 2008 2009 2010 2011 2005-11
12 Sales $870.0 $1,000.5 $1,150.6 $1,323.2 $1,521.6 $1,749.9 $2,012.4

Sources:
13 Net income 18.1 40.0 57.5 72.8 91.3 98.0 160.0 537.7
14 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.0
15 Total sources 40.6 65.5 87.5 107.3 131.8 144.5 212.5 789.7

Uses:
16 Capital expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6
17 Working capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
18 Total uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

19 Excess cash (borrowings) (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6 119.9
20 Dividends 7.2 16.0 23.0 29.1 36.5 39.2 64.0 (215.1)
21 Net (29.9) (23.3) (18.8) (17.6) (7.2) (12.0) 13.6 (95.1)
22 Cumulative source (need) (29.9) (53.2) (72.0) (89.6) (96.8) (108.8) (95.1)
23 Int. cost-new debt (1.2) (2.1) (2.8) (3.5) (3.8) (4.2) (3.7) (21.3)
24 Net source (need) (31.1) (55.3) (74.8) (93.1) (100.6) (113.0) (98.8)
25 Debt (excess) 111.4 136.7 158.4 179.4 190.4 206.6 196.7 169.9
26 Equity 292.2 314.2 345.9 386.0 437.0 491.6 583.9 511.0
27 Debt/equity 38.1% 43.5% 45.8% 46.5% 43.6% 42.0% 33.7% 33.2%
28 Unused debt capacity 5.5 (11.1) (20.0) (25.0) (15.6) (10.0) 36.9 34.5

29 Return on avg. equity 5.9% 12.5% 16.6% 18.9% 21.3% 20.2% 29.1%
30 EPS $0.91 $2.04 $2.94 $3.73 $4.71 $5.04 $8.40
3
31 Implied stock price $22.44 $50.29 $72.52 $91.82 $116.00 $124.26 $207.12
32 Dividends per share $0.39 $0.86 $1.24 $1.57 $1.96 $2.11 $3.44

Return to investor:
33 Stock value (terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $207.12
34 Dividend received $0.39 $0.86 $1.24 $1.57 $1.96 $2.11 $3.44
35 Total cap. apprec. & divs. ($22.15) $0.39 $0.86 $1.24 $1.57 $1.96 $2.11 $210.56
36 NPV (@ 12%) $78.19
37 Return (IRR) 40.0%
1
The model adds any excess cash flow, which results in negative debt, to the base to calculate unused debt capacity at a maximum debt/equity
ratio of 40%.
2
This is the weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Gainesboro’s targeted business mix, a weight
of 75% is assigned to the average P/E of the CAD/CAM companies and 25% is assigned to the average P/E of the electrical industrial-equipment
and machine-tool manufacturers.
3
EPS times assumed P/E.
 -20- UVA-F-1489TN

Exhibit TN6
GAINESBORO MACHINE TOOLS CORPORATION
Forecast of Financing Need Assuming 20% Payout1
(dollars in millions)

Common Assumptions
1 Sales growth 15.0%
2 Net income margin 2.1% 4.0% 5.0% 5.5% 6.0% 5.6% 8.0%
3 Dividend payout 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
4 Beginning debt 80.3
5 Beginning equity 282.5
6 Shares outstanding 18.6
7 Price earnings ratio2 24.6
8 Current market price $22.15
9 Debt/equity maximum 40.0%
10 Borrowing rate 6.0%
11 Tax rate 35.0%
Total
2005 2006 2007 2008 2009 2010 2011 2005-11
12 Sales $870.0 $1,000.5 $1,150.6 $1,323.2 $1,521.6 $1,749.9 $2,012.4

Sources:
13 Net income 18.1 40.0 57.5 72.8 91.3 98.0 160.0 537.7
14 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.0
15 Total sources 40.6 65.5 87.5 107.3 131.8 144.5 212.5 789.7

Uses:
16 Capital expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6
17 Working capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
18 Total uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

19 Excess cash (borrowings) (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6 119.9
20 Dividends 3.6 8.0 11.5 14.6 18.3 19.6 32.0 (107.5)
21 Net (26.3) (15.3) (7.3) (3.0) 11.1 7.6 45.6 12.4
22 Cumulative source (need) (26.3) (41.6) (48.9) (51.9) (40.8) (33.2) 12.4
23 Int. cost-new debt (1.0) (1.6) (1.9) (2.0) (1.6) (1.3) 0.5 (9.0)
24 Net source (need) (27.3) (43.2) (50.8) (54.0) (42.4) (34.5) 12.9
25 Debt (excess) 107.6 124.5 133.7 138.8 129.3 123.0 76.9 50.1
26 Equity 296.0 326.4 370.5 426.7 498.1 575.2 703.7 618.6
27 Debt/equity 36.4% 38.2% 36.1% 32.5% 26.0% 21.4% 10.9% 8.1%
28 Unused debt capacity 10.8 6.0 14.5 31.9 70.0 107.1 204.6 197.3

29 Return on avg. equity 5.9% 12.3% 16.0% 17.7% 19.4% 18.0% 25.1%
30 EPS $0.92 $2.06 $2.99 $3.80 $4.82 $5.20 $8.63
3
31 Implied stock price $22.62 $50.89 $73.72 $93.77 $118.89 $128.16 $212.68
32 Dividends per share $0.19 $0.43 $0.62 $0.78 $0.98 $1.05 $1.72

Return to investor:
33 Stock value (terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $212.68
34 Dividend received $0.19 $0.43 $0.62 $0.78 $0.98 $1.05 $1.72
35 Total cap. apprec. & divs. ($22.15) $0.19 $0.43 $0.62 $0.78 $0.98 $1.05 $214.40
36 NPV (@ 12%) $77.38
37 Return (IRR) 39.3%
1
The model adds any excess cash flow, which results in negative debt, to the base to calculate unused debt capacity at a maximum debt/equity
ratio of 40%.
2
This is the weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Gainesboro’s targeted business mix, a weight
of 75% is assigned to the average P/E of the CAD/CAM companies and 25% is assigned to the average P/E of the electrical industrial-equipment
and machine-tool manufacturers.
3
EPS times assumed P/E.
 -21- UVA-F-1489TN

Exhibit TN7
GAINESBORO MACHINE TOOLS CORPORATION
Forecast of Financing Assuming Residual Dividend Policy, Lower Growth, and Lower Margins1
(dollars in millions)

Common Assumptions
1 Sales growth 12.0%
2 Net income margin 1.1% 3.0% 4.0% 4.5% 5.0% 4.6% 7.0%
3 Dividend payout 21.3% 0.0% 0.0% 4.8% 28.9% 21.3% 45.4%
4 Beginning debt 80.3
5 Beginning equity 282.5
6 Shares outstanding 18.6
7 Price earnings ratio2 24.6
8 Current market price $22.15
9 Debt/equity maximum 40.0%
10 Borrowing rate 6.0%
11 Tax rate 35.0%
Total
2005 2006 2007 2008 2009 2010 2011 2005-11
12 Sales $870.0 $974.4 $1,091.3 $1,222.3 $1,369.0 $1,533.2 $1,717.2

Sources:
13 Net income 9.6 29.2 43.7 55.0 68.4 70.5 120.2 396.6
14 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.0
15 Total sources 32.1 54.7 73.7 89.5 108.9 117.0 172.7 648.6

Uses:
16 Capital expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6
17 Working capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
18 Total uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

19 Excess cash (borrowings) (31.2) (18.1) (9.7) (6.3) 6.5 (0.2) 37.8 -21.1
20 Dividends 2.0 0.0 0.0 2.6 19.8 15.0 54.5 (94.0)
21 Net (33.3) (18.1) (9.7) (8.9) (13.3) (15.3) (16.7) (115.1)
22 Cumulative source (need) (33.3) (51.3) (61.0) (69.9) (83.2) (98.4) (115.1)
23 Int. cost-new debt (1.3) (2.0) (2.4) (2.7) (3.2) (3.8) (4.5) (20.0)
24 Net source (need) (34.6) (53.3) (63.4) (72.6) (86.4) (102.2) (119.6)
25 Debt (excess) 114.8 134.9 147.0 158.6 175.1 194.2 215.3 188.6
26 Equity 288.8 316.0 357.3 406.9 452.3 504.0 565.2 491.1
27 Debt/equity 39.8% 42.7% 41.1% 39.0% 38.7% 38.5% 38.1% 38.4%
28 Unused debt capacity 0.7 (8.5) (4.0) 4.2 5.9 7.4 10.7 7.8

29 Return on avg. equity 2.9% 9.0% 12.3% 13.7% 15.2% 13.9% 21.6%
30 EPS $0.44 $1.46 $2.22 $2.81 $3.51 $3.59 $6.22
3
31 Implied stock price $10.96 $36.09 $54.70 $69.29 $86.42 $88.39 $153.37
32 Dividends per share $0.11 $0.00 $0.00 $0.14 $1.06 $0.81 $2.93

Return to investor:
33 Stock value (terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $153.37
34 Dividend received $0.11 $0.00 $0.00 $0.14 $1.06 $0.81 $2.93
35 Total cap. apprec. & divs. ($22.15) $0.11 $0.00 $0.00 $0.14 $1.06 $0.81 $156.30
36 NPV (@ 12%) $49.75
37 Return (IRR) 32.7%
1
The model adds any excess cash flow, which results in negative debt, to the base to calculate unused debt capacity at a maximum debt/equity
ratio of 40%.
2
This is the weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Gainesboro’s targeted business mix, a weight
of 75% is assigned to the average P/E of the CAD/CAM companies and 25% is assigned to the average P/E of the electrical industrial-equipment
and machine-tool manufacturers.
3
EPS times assumed P/E.
 -22- UVA-F-1489TN

Exhibit TN8
GAINESBORO MACHINE TOOLS CORPORATION
Calculation of Intrinsic Value
(dollars in millions)

Assumptions:
WACC 10.0%
Terminal value growth rate 3.5%

Time period 0 1* 2 3 4 5 6
Year 2005 2006 2007 2008 2009 2010 2011

Net income 18.1 40.0 57.5 72.8 91.3 98.0 160.0

Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5
EBITDA 40.6 65.5 87.5 107.3 131.8 144.5 212.5

Capital expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6

Change in working capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
63.3 72.8 83.3 95.8 102.4 117.3 134.9

Free cash flow (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6
Terminal value 1,236.3
(22.7) (7.3) 4.2 11.5 29.4 27.2 1,314.0

Discounted cash flows (22.7) (6.6) 3.5 8.7 20.1 16.9 741.7

Enterprise value 761.5

Less: debt 106.5
Equity value $ 655.0
Outstanding shares 18.6
Equity value per share $ 35.22
Current share price $ 22.15
Premium over current share price 59.0%

*
A time period of 1 is assumed for simplicity. In reality, the factor should be around 1.25.