Gainesboro Machine

Tools Corporation

FIN-480-01

Professor Beaudin

4/2/18

John Reilly

Jacob Diesu
Executive Summary:

In mid-September 2005, Ashley Swenson, CFO of Gainesboro Machine Tools Corporation

needed to submit a new dividend policy recommendation to the board of directors. The policy

has been an ongoing debate amongst the firm’s senior managers. Weeks after Hurricane

Katrina, the stock market had taken a hit. Gainesboro’s stock had fallen 18%, to $22.15 As a

response to the market shock many companies had announced plans to buy stock. While some

were motivated by a desire to signal confidence in their companies as well as the markets,

others had opportunistic reasons. Ashley Swenson is posed with the dilemma of whether to use

company funds to pay out dividends to shareholders or to buy back stock.

Traditionally, Gainesboro has had strong earnings and predictable dividend growth. The

past five years have not kept up to this standard. As a response management implemented two

extensive restructuring programs that lead to net losses. For three years since 2000 dividends

had exceeded earnings, and then in 2003 decreased to a level below earnings. As the company

continued to struggle they continued to declare a small dividend until 2005 and sent out a

letter to shareholders where they committed themselves to resume dividend payments as soon

as possible.

Senior management has also considered a campaign of corporate-image-advertising

which planned to change their name to “Gainesboro Advanced Systems International, Inc.”

With the belief that it would improve the investment community’s perception of the company.

Overall, the internal belief was that Gainesboro demonstrated potential for growth and

profitability. With new technology and product advancements that would consider the

competitions products obsolete, many believed 2005 was going to be the dawn of a new era
which would turn the company back into a growth stock. Swenson considers what the

perception of the company currently is and thinks on how the new dividend policy might affect

that perception.

The company was founded in 1923 in Concord, New Hampshire, by mechanical

engineers, James Gaines and David Scarboro. Early production consisted of metal presses, dies,

and molds which then lead into armored-vehicle and tank parts. By 1975 the company had

developed a positive reputation and by 1980, had entered the field of computer-aided design

and computer-aided manufacturing (CAD/CAM). By 2004 CAD/CAM equipment and software

was responsible for 45% of sales, presses, dies and molds made up 40% of sales, and

miscellaneous machine tools made up 15% of sales.

Gainesboro was an industry leader for a long time, but as the entry of foreign firms grew

and the rise of the U.S. dollar had caused sales to struggle. Gainesboro began to fall behind its

competitors and revenues sunk from $911 million, in 1998, to $757 million, in 2004. In efforts

to improve Gainesboro increased its research and development, sold off under profitable lines

of business and two plants, and eliminated 5 leased facilities. The restructurings produced

losses totaling $202 million in 2002 and 2004.

2005 launched a turnaround into the CAD/CAM industry that Gainesboro believed

would redefine the industry. Their new prominent system was called the Artificial Workforce,

and when the first Artificial Workforce had shipped, Gainesboro had orders totaling $75 million,

leading to $100 million by years end. The future of this product looked very bright and security

analysts had confirmed. Gainesboro had expected both domestic and foreign growth of their
product. Potential issues were 2 strong competitors who were developing a similar product and

the strength of the U.S economy was not encouraging.

Corporate goals consisted of an annual growth rate of 15% compounded, an aggressive

expansion into the international market by and opening new field sales office around the world

and expand through joint ventures and acquisitions of small software companies. One of the

biggest priorities expressed by David Scarboro is to never exceed a 40% debt-to-equity ratio.

2004 lead to the company’s highest debt-to-equity ratio in the past 25 years at 22%.

Gainesboro’s management also placed the interest of outside shareholders making it a priority

to pay out a dividend if possible.

The company is contemplating three different dividend policies; a zero-dividend payout,

which would be justified based on the huge cash requirements needed to advance technologies

and CAD/CAM. It would signal that the firm belonged in the category of high-growth/ high-

technology which was questionable. Also, the percentage of firms paying out cash dividends

had dropped from 66.5% in 1979, to 20.8% in 1999, which lead to the belief that perhaps the

market would react favorably.

Another option was a 40% dividend payout policy. This would restore the firm to an

annual payment of $0.80 a share, the highest since 2001. This was justified by expected

increases in sales and the fact that it would put them back in line with their industry’s average

dividend payouts (36% average in Electrical-industrial-equipment industry and 26% average in

machine-tool industry). It would also suggest the company had conquered its struggles and

promote strength. Older managers also expressed that a company with a growth rate between

10%-20%should accompany a dividend between 30%-50%

 The final option was a residual-dividend payout which would require dividends only to

be paid after the company had funded all the projects that offered a positive NPV. This would

only allow excess capital to be paid out to investors and was believed it would build trust with

investors and be rewarded through higher valuation multiples. On the other hand, it also would

lead to an unpredictable dividend payout which could negatively affect the firms share price.

The company’s final corporate considerations is the Image advertising and name

change. It was concluded that investors were misperceiving the firm’s prospects and that the

current name was more consistent with its historical product mix than with its future projects.

Surveys showed either a low awareness of the business or a low outlook on returns. It was

believed that the rebranding would help enhance the firm’s visibility and image. Although no

empirical evidence could suggest that stock prices would respond positively from a rebrand,

some favorable anecdotes were offered. The rebrand would cost roughly $10 million.

1. Make a concise statement of the problem here. What are the conflicting issues?

The main problem in this case is whether management sees Gainesboro Machine Tools

Corporation as a dividend paying blue chip stock or an up and coming tech growth stock. This

identity crisis is evident in the decisions the firm has made in the past several years. The firm

underwent a $202 million restructuring project which set up the company to focus more on

CAD/CAM technology which includes their new ground breaking Artificial Workforce system.

This points to them being a growth stock, as stated in the case “Overall, management’s view

was that Gainesboro was a resurgent company that demonstrated great potential for growth
and profitability”. At the same time, they continued to pay dividends which implies they see

themselves as a blue-chip stock. These contradicting actions show a level of confusion within

management.

2. What policy does a consideration of future cash needs imply? Why? The board has
stated that it doesn’t want the company’s debt/equity ratio to exceed 40%. What
does the 40% dividend payout ratio (dividends/net income) incorporated in the cash
flow projection shown in Exhibit 8 imply about the debt to equity ratio over time? Is
the 40% debt to equity ratio restriction met in every year? Could more be paid out in
dividends and still meet it?

A consideration of future cash needs implies the residual-dividend payout policy. The residual-

dividend payout policy is the only policy that takes into consideration the future cash needs of the

company, while still works to payout a dividend based on excess cash. The company has typically made

paying out dividends such a priority that they have taken on extra debt in order to pay them. The

residual policy will restrict that and only allow dividends to be paid out after the company has funded all

the projects that offered a positive NPV.

The company has had an aversion to debt since its inception. Management believed that small

amounts of debt, primarily to meet working-capital needs, had their place, but anything beyond a 40%

debt-to-equity ratio was “unthinkable”. Exhibit 8 expresses a projected sources and uses statement that

assumes a 40% dividend payout ratio. This statement implies that if the company grows at the optimistic

rate of 15% each year, then Gainesboro will experience a positive cash flow in the year 2011. What is

interesting about this is that no year comes close to a 40% debt-to-equity ratio. The highest debt-to-
equity ratio occurs in 2004 at a ratio of 22.26% This is almost half of what Gainesboro would deem as an

acceptable rate.

In fact, if we continue using this mentality, Gainesboro can afford to pay out an even higher

dividend each year without exceeding their 40% limit. We applied a multitude of higher dividend rates

to each year’s excess cash and concluded that Gainesboro can successfully implement a 58.62% dividend

return and experience their highest debt-to-equity ratio of exactly 40% in the year 2006. 2006 will be

the only year that will have a debt-to-equity ratio that reaches 40%, 2001 will have a debt-to-equity

ratio of 11.18%, 2002 will have a 20.22%, 2003 will have a 27.60%, 2004 will have a 33.66%, 2005 will

have a 36.52% and 2007 will experience a lower debt-to-equity ratio than 2006 at 37.92. So, Gainesboro

would be able to successfully implement a 58.62% dividend payout without breaching their limit of a

40% debt-to-equity ratio.

3. The big issue in the dividend controversy is whether paying dividends affects stock
price. In this case why is the board likely to care? Who are the stockholders?

It is very clear that any management decision related to the dividend will affect the stock

price. Before making a decision though, the board must understand that the company is no

longer what it used to be and is looked at as a technologically advanced CAD/CAM company in

the market. They must also be aware of the shift within their investor demographics and the

effect that has on dividend expectations.

Historically, Gainesboro has paid dividends which increase an average of 19.5% YOY, this

trend held steady from 1989 to 1999. In the late 90’s Gainesboro began to fall behind its

competition and as a result the dividend remained stagnant from 1999-2001. Following several
years of decreasing revenue, the dividend was cut by 25% in 2002 and an additional 67% in

2003, reaching its lowest level since 1990. These five years of disappointing dividend payouts

had caused investors seeking dividends to leave the company while attracting a new type of

investor. This is evident when looking at stockholder data from the years 1994 and 2004. In

1994 37% of all Gainesboro’s stockholders were long term retirement investors, by 2004 that

number had dropped to only 26%. Traditionally, dividend stocks have been a staple in

retirement accounts because of the quarterly cash payments and ability to go tax free if held in

a Roth IRA. This exodus of retirement investors from Gainesboro’s stock shows deep concern

related to the future dividends expected from the company. Over that same time period the

percentage of short-term trading-oriented investors grew from 5% to 13%. This shift in investor

demographics shows that less investors are expecting a dividend but rather looking for increase

in the stock price.

The shift in institutional investor demographics goes against this as the percentage of

growth-oriented investors dropped from 13% to 6%. However, value-oriented investors

increased from 8% to 13%. This can be explained by the stock price which dropped to $18.38

per share in 2004, a level not seen since 1995. This will obviously attract the attention of

institutional investors who are looking for a stock that is on sale and has upside potential. So,

while the level of growth-oriented investors may have decreased because of several bad years,

the increase in value-investors supports the notion that investors are not necessarily looking for

dividends from this company. For these reasons, an announcement saying that they are no

longer paying out dividends would not have a huge effect on the stock because there is only a

small percentage of stockholders actually expecting one. There will obviously be an initial
reaction to the news which would lower the stock price. This negative effect be short lived as

investors will see the benefits to the company by freeing up more capital to be reinvested,

buying back stock and ultimately raising the stock price.

Now that it is clear that investors are no longer looking for dividends we can address the

boards letter to shareholders and the problems that it will cause. In this letter, the board said

they would not be paying dividends the first two quarters of 2005 but were committed to

resume paying a dividend as soon as possible. In my opinion this is worse than saying they will

pay no dividend at all for a couple reasons. First, investors will see this dividend as just another

expense on an already ugly few years of income statements plagued with large capital losses

and terrible EPS performance. Management would only be hurting themselves by ignoring their

financial statements in order to act like a blue chip. The second reason is the risk of the

proposed dividend not meeting investor expectations. From 1989 to 1999 the dividend yield

averaged 30.6% of the EPS. This value obviously varied drastically between 2000 and 2004

when the DPS was often larger than the EPS but its safe to assume that the investors who

expect dividends are looking for something in line with that historical 30% yield. If the dividend

that comes out in 2005 is not at or above 30% of EPS, then there is serious risk that the stock

price drops because it failed to meet investor expectations. Some people in management even

believe that this will be too low and that a payout of 40% would be required to suggest that the

company has conquered its financial troubles. Either way, a dividend payout seems to have

more negative outcomes than positive, especially given the firms strategic moves towards

becoming a growth stock.

 4. The immediate signaling effect of a dividend might work in two different ways in this
situation. What are they? Are they in conflict?

The immediate signaling effect of a dividend has the potential for two very different outcomes that

stockholders could undertake. Much like how Gainesboro’s management has very diverse points of view

on this situation it makes sense to assume that the mentality of shareholders is equally as diverse.

Investors will always respond positively to being issued a dividend. Investors are understandably very

difficult to please as it is their capital that is taking a risk, so it is understandable that anytime there is a

change in the dividend policy it will lead to a reaction from investors.

Gainesboro is currently divided between two main signaling effects of a dividend payout. If

Gainesboro decides not to pay out a dividend then this will mean that they will have the ability to

reinvest as much capital possible back into the company. On the other hand, if they decide to layout a

dividend to stockholders it would lead to their stock price rising and ultimately instill confidence back

into investors. Typically, the more mature industrial companies have been issuing consistent dividends

which arises a conflict putting pressure on Gainesboro. There is also the matter of the proponents of the

zero-dividend policy who argued it would signal that the firm now belonged in a class of high-growth

and high-technology firms. This brings up a conflict because security analysts are going to question

whether the market considers Gainesboro a traditional electrical-equipment manufacturer or a more

technologically advanced CAD/CAM company. How the market perceives Gainesboro will go hand and

hand with whether or not investors will look at this policy as financially healthy.

Stock prices tend to increase when an increase in dividends is announced and tend to decrease

when a decrease is announced. Changing the policy by implementing a zero-dividend policy will cause

the cash-oriented investors like those who rely on the dividend payout as income and long-term

retirement investors to be harmed. Whereas issuing a 40% dividend payout would restore the firm to
the highest implied annual dividend payment ($0.80 a share) since 2001. Implementing this large

dividend would send a strong signal to shareholders that would help them regain trust in the firm.

Stockholders will remain with the company and the potential to acquire more investors will grow.

Ultimately, issuing a dividend will mean nothing if the company fails to meet its expectations.

The optimistic expectation that the company will grow at a 15% compound rate and that margins would

improve into historical levels is a bold statement. If a 40% dividend payout it established, Gainesboro

will not experience a positive cash flow until 2011 even if the growth expectations are met. This poses a

long-term risk of success, if the expectations Ashley suggested are not met, it will take even longer for

Gainesboro to experience a positive cash flow.

5. What do you think of the image advertising currently under consideration? Should
that decision be tied to the dividend decision? How and why?

The decision to rebrand themselves is directly related to the dividend decision. Over the

past 20 years Gainesboro Machine Tools Corporation has strayed very far from the company it

used to be, which designed and manufactured machinery parts, dies and molds. This is

something that Cathy Williams, the director of Investor Relations, has brought up saying

investors misperceive the firm’s prospects as its name is no longer consistent with its current

and future products. Gainesboro has become an increasingly big player in the computer-aided

manufacturing (CAD/CAM) sector since they entered the market in the 1980s they have

expanded overseas with international sales accounting for 15% of all revenue. In the 1990s they

had set the standard for all CAD/CAM software but the entry of much larger firms such as

Autodesk Inc, Cadence Design, and Synopsys Inc caused them to fall behind. With revenues
falling $154 million from $911 to $757 over a six-year period from 1998 to 2004 the company

began a two-pronged restructuring effort. This included spending more money on research and

development for CAD/CAM in an effort to reestablish its development in the field. This also

included two massive restructuring efforts where they sold off two unprofitable lines of

business, two plants, eliminated five leased facilities and reduced personnel, this cost the

company $65 million. They then underwent a second restructuring effort in 2004 when it

altered its manufacturing strategy, refocused its sales and marketing approach and eliminated

more personnel, this cost the company $89 million. These two restructuring efforts produced a

loss of $202 million but allowed the company to focus more on CAD/CAM research. This is in

addition to the company’s newly developed machine tools which promised to make the

competitors products obsolete.

All of these actions as well as their new products show that the company is moving towards

becoming an up and coming tech stock. When they change the name of the company to

Gainesboro Advanced Systems International Inc, they are signaling that they are focused on

growth. Management has predicted that international revenue will reach $150 million by the

year 2011, further showing that Gainesboro has huge growth potential. A growth company

needs to reinvest all of its net income back into the company in order to continue improving its

products and gaining a competitive edge over its competitors. Because they are taking so many

actions to promote growth, they should not be paying out a dividend. This is why the

rebranding is directly tied to the dividend. When Gainesboro rebrands themselves they are

signaling to all investors that there has been a massive shift in the company’s operating

strategy. They will no longer be a company with a stock price that grows incrementally higher
each year but pays consistent dividends, but rather a company with no dividends and explosive

growth in its stock price.

6. Could the signaling effect of paying a dividend backfire in this case? In other words
could paying dividends affect the firm in a way that would cause investors to devalue
it beyond considerations of image?

The signaling effect of paying a divided will backfire on Gainesboro Machine Tools

Corporation in many ways. Investors have been aware of GMTC’s poor performance for the

past several years. This includes decreases in sales and even years with very large losses in net

income. These have made many investors skeptical of the company, but management has

made the issue even worse by continuing to pay out dividends. For three years in a row since

2000, the dividends paid out have exceeded the company’s earnings. In 2000, the dividend per

share (DPS) was $1.03, with earnings per share (EPS) of $.65. In 2001 EPS was $.35 with DPS of

$1.03, in 2002 EPS was $-3.25 with DPS of $.77. Finally, in 2003, management cut the dividend

to a level lower than earnings with EPS of $.69 and DPS of $.25. Management would continue

to keep this $.25 dividend payout policy in 2004 where the company recorded its largest losses

in history of $-7.57 per share and had to borrow funds in order to pay these dividends. This

total lack of effective capital management has scared off many dividend investors, the

percentage of long term retirement investors has dropped 11% since 1994. This shows that
investors are nervous about the company’s future dividend policy and many have sold their

positions in the stock because of that. By signaling that they will continue to pay a dividend

they are implying huge risk and this will scare even more investors off causing the stock price to

fall. The decision to pay dividends also goes against almost all restructuring efforts the company

has completed in the past several years which have cost the company over $200 million and all

point to a growth stock. Paying dividends signals an identity crisis within company management

which could hurt the stock even more in upcoming years.

7. What should Ashley Swenson recommend?

Ashley Swenson should recommend a zero-dividend payout policy moving forward. In the

past few years Gainesboro has spent hundreds of millions of dollars restructuring and setting

itself up for future growth. Most importantly, the company has begun to roll out its

groundbreaking Artificial Workforce system that management believes will redefine the

CAD/CAM industry. With this new system a product can be designed, manufactured, and

packaged solely by computer no matter how intricate it may be. This new system moves past

the traditional manufacturing of machine parts and molds that Gainesboro specialized in.

Applications of this product can currently be used in the chemical industry as well as oil and gas

refining. By next year applications for the trucking, automobile-parts, and airline industries will

be on the market. This will propel Gainesboro to the front of the pack as it will have truly

revolutionized the manufacturing process for industries that do trillions of dollars of business

each year.
 With such huge growth expected in the coming years, the company will need to utilize all of

its available capital in order to continue making innovations in CAD/CAM technologies and stay

one step ahead of its competition. This decision to cut the dividend is right in line with what

many securities analysts were wondering, whether the market still considered Gainesboro a

traditional electrical-equipment manufacturer or a more technologically advanced CAD/CAM

company. Cutting the dividend is also in line with a broader industry trend of not paying

dividends. In 1978, 66.5% of companies paid dividends with that dropping down to 20.8% in

1999.

8. What do you think of Swenson’s qualifications to be CFO? Could she be in over her
head? Why? If she is under-qualified would it be likely to show up in an issue like this
or on something else? What kind of issues would give her the most problems?

According to Stephen Gaines, he took a particular pride in selecting and developing promising

young managers. Ashley Swenson had a bachelor’s degree in electrical engineering and had been a

systems analyst for Motorola before attending graduate school. Swenson was hired in 1995, fresh out of

a well-known MBA program. By 2004, she had risen to the position of CFO. Having a MBA from a “well

known” school absolutely makes Ashley Swenson qualified for an executive position in a company.

However, those qualifications do not make her well acquitted for the executive position as the chief

financial officer. Her bachelor’s degree in electrical engineering and then a Master of Business

Administration degree makes her a more qualified candidate for the chief operations officer instead.

Ashley has no form of financial experience or education and thus is not fit to be CFO. The beginning of

the case states that when Ashley was presented with the issue regarding the company’s dividend policy

that she was pacing the building of the Minnesota office suggests that even Ashley knows she is in over

her head. Her lack of qualifications will undoubtedly become visible to the rest of the executives during
this issue. As a CFO her responsibilities lie specifically on managing the company’s finances and being

able to make educated decisions based on the analytics available.

Relatively speaking, the list of issues that would give her the most problems is virtually endless.

Without a proper basis of financial education virtually every financial decision she encounters will be

through the process of trial and error and/or the advisement of an outside party. We see this in each of

the three policies she is considering. For the zero-dividend payout she is basing the results off of some

security analysists, for the 40% dividend payout she is basing results off of Gainesboro’s investment

banker’s suggestion, and for the residual-dividend payout she is basing results off of a few members in

the finance department. At no point does she express her own thoughts and analysis. Even her decision

to test the feasibility of a 40% dividend-payout rate is based off of the opinion of some older managers

that expressed to her that a growth rate in the range of 10% to 20% should accompany a dividend

payout of between 30% and 50%. It seems like she very well might have just split both rates down the

middle and went with it.