1.What are the problems here, and what do you recommend?
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. In addition, please check TN_26 provided in blackboard which will help you verify this question. Pays no dividends – If it pays no dividends, then Gainesboro would be able to channel all its earnings to fund its growth strategy. Its unused debt capacity would be channelled towards the high cash requirements of the firm’s strategic emphasis on advanced technologies and CAD/CAM.
20% – With a 20% payout ratio, the firm would have positive excess cash from 2009 instead positive excess cash from 2011 with a 40% payout ratio. This will enable the firm to use its excess debt capacity to fund its expansion needs, keeping within the debt-equity ratio of 40%.
40% – With a 40% payout ratio, the projections of 2005 would leave the debt equity ratio at 35%, which still gives the firm some debt capacity, albeit very little flexibility if it wants to keep within the 40% debt equity ratio. Perhaps the firm would have to exceed this threshold to meet its strategic growth needs, and seek more financing.
Residual dividend – The financing requirements would be less than that of the 20% and 40% payout, as dividends are paid only after Gainesboro has funded all the projects that offered positive net present values.
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? Each of the three options have their own potential advantages and disadvantages based on the growth stage of the firm and investors perspective i.e, if it is income seeking investor or capital gains investor or creditor.
Generally firms that are mature tend to pay high dividends because there are few opportunities for growth; whereas, firms that have high growth prospects pay low/no dividends because they would reinvest the excess cash from the earnings for future growth opportunities. With reinvestments, firm could generate more returns to the investors. This would not only help the firm compete in the market place but could also increase the capital gains of the investors in terms of increase in firm’s share price.
Zero Dividend Payout Policy: Because Gainesboro is trying to reposition itself as software and high‐technology firm that has high growth potential, it could adopt a zero dividend payout policy. Although, income‐seeking investors such as the retirees may be un‐attracted to a zero‐dividend policy, non-dividend seeking investors who prefer increased value in stock price instead of cash distribution might prefer this option.
Moreover from exhibit 4 it can be seen that the firm’s traditional clientele, the long-term retirees, has reduced from 1994 to 2004; while the short-term trading oriented clientele has increased during the same period.
40% Payout: The advantage of this approach is that the firm would start repaying the dividends as it had promised to the investors. This could boost market confidence back in the firm and result in a positive increase in share price. But the disadvantage is that the Gainesboro will have to borrow more funds, which is against the firms strategy, to fund the dividends and its expansion plans
Residual Payout: This policy gives Gainesboro the flexibility to pay dividends, no matter how small, to the investors as promised after funding the projects with positive NPVs, which would increase sales and growth prospects for the company. The con of this approach is that there would be lot of fluctuations in the dividends paid over the years, there could also be periods of zero dividends; thereby, imposing negative pressure on the company.
Based on the growth strategy of Gainesboro, Swenson should pay dividends as promised to the investors in 2006 and adopt a zero dividend payout policy after 2006. Gainesboro should invest the excess cash to achieve its growth goal; and after the company reaches a mature stage it should start paying dividends like other mature firms in the market.