Gainesboro Machine Tools Corporation - Essay

Executive Summary

Gainesboro Corporation was a company who designed and manufactured a number of machinery parts, including metal presses, dies, and molds. The company was found in 1923 in Concord, New Hampshire, by two mechanical engineers, James Gaines and David Scarboro. The two men had gone to school together and were disenchanted with their prospects as mechanics at a farm equipment manufacturer. In the 1940’s Gainesboro produced armored-vehicle and tank parts and miscellaneous equipment for the war effort. And then in the early 1980’s, they focused on manufacturing machinery parts, war equipment, and now entered new field of computer aided design and computer aided manufacturing (CAD/CAM).

Objective
Ashley Swenson, chief financial officer (CFO) in mid-September 2005 needed to submit recommendation to Gainesboro’s board of directors regarding the company’s dividend policy. The Gainesboro’s stock also fallen 18%to $22.15 due to post impact of the Hurricane Katrina. Now, Ashley Swenson’s dividend decision problem was compounded by the dilemma of whether to use company funds to pay shareholder dividends or to buy back stock.

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Analysis
>>Buy-back Stock
Stock Price per share = $22.15
Net income in year 2005 = $18,018,000
Number of shares = 18,600,000 shares (assumed number in year 2004 is
still the same with year 2005)
Earnings per share = $0.98
Price to earnings ratio ( P/E Ratio)=(Price per share)/EPS
P⁄E Ratio=22.15/0.98=22.6
Number of retired shares=(Net income)/(Price per share)
Number of retired shares=18,018,000/22,15=813,453.72≈813,454

Therefore, number of shares outstanding
=18,600,000-813,454=17,786,546 shares

Then we can calculate the new EPS after repurchase stock,
Earnings per Share (EPS) =(Net income)/(Number of shares)
EPS =$18,018,000/17,786,546=$1,013
Thus, the new market price is =EPS x PE Ratio=1.

013 x 22.6=$22.89 It can be seen that by buying back the stock, the market price can increase for 3.34%.

>Pay shareholders dividend
a. Zero dividend payout Policy

This policy required the company will not pay dividend from 2005 to 2011.In the year 2005, The company expenditure was about $63.3 million dollars but the amount of the total sources was only $40 million, so in order to balanced the company financial condition, the company borrowed $22.7 million. The same thing was also happened in 2006, the company borrowed $7.3 million (total expenditure $72.8 million –total source $65.5 million). From 2007 to 2011, the company excess cash are positive ($4.2, $11.5, $29.4, $27.2, $77.6) million, these situation happened because the total expenditure remained lower than the company total source, so the company did not have to borrowing needs.

So, by sum all of the excess cash and the borrowed money data from 2005 to 2011, we can calculate that the company total excess cash is $120 million. This kind of policy has the best impact on company’s financial condition because of the absence of dividend that will reduce the company’s retained earnings. Retained earning posses a greater role to make sure the company runs smoothly in the future by using minimum portion of debt required on a project, reflected in the industrial zero-dividend payout ratio.

b. 40% dividend Payout
From data in exhibit 8, 40% dividend payout means that the company will pay dividend 40% from net income from year 2005 to 2011. This results and the total excess cash for borrowing needs from 2005 to 2011 is ($95.1) million.

The company will do borrowing from year 2005 to 2010. Amount of money borrowed respectively, ($29.9), ($23.3), ($18.8), (17.6), ($7.2), and ($12.0). All of the value comes from deduction of the total expenditures to the total sources.

Year 2011 the company will get $13.6 million excess cash ($212.5 million - $134.9 million). $134.9 million is from the total expenditures (capital expense + change in working capital). And $212.5 million comes from the total sources (net income + depreciation).

By sum up all of values (excess cash and borrowed money) from year 2005 to 2011 we get the total cash flow of ($95.1) million. By raise dividend payout from 31.4% in 2004, 140,784(Net income)/0.25(dividend per share) to 40% company need excess cash 95.1 million; only in 2011 the company gain profit. The following is the calculation table:

c. Residual-payout Dividend
The following is the calculation for the residual-dividend payout:

By applying residual payout policy, at the total of excess cash from year 2005 to year 2011, Gainesboro still experiences negative cash. It means they will still have to borrow extra cash to pay the dividend.

Conclusion and Recommendation
Based on the market price value, EPS, and P/E Ratio calculation, the company’s stock will have higher market price if they buy back the stock. Therefore, it’s recommended to buy back stock instead of paying dividend. It is also supported by the comparison between zero payout dividend, 40% payout ratio, and residual-payout. The best ending cash the company has is when they do zero payout ratio, which means they don’t give dividend at certain years. Since, to pay the dividend they will have borrowing need forcing them to increase the debt level. Meanwhile, they current debt level is already higher than the maximum level management expect which is 40%. The year 2005 debt to equity ratio is 140%. Also, without paying dividend, the company still can attract investors. It is shown from the P/E ratio that is in average if compared to other similar companies.