Case Analysis of GAINESBORO MACHINE TOOLS CORPORATION: The Dividend
Policy
By: Gholamreza Soleimani
“A New Financial Simulation Model for Case Analysis of GAINESBORO MACHINE TOOLS
CORPORATION”
https://emfps.blogspot.com/2012/04/case-analysis-of-gainesboro-machine.html
https://emfps.blogspot.com/2012/03/case-analysis-of-gainesboro-machine.html
This case is about the impact of an environmental factor (External issue) on dividend policy of
the firm (Internal issue). The environmental disaster was Hurricane Katrina which was caused
the huge destruction across the south-eastern United States. Because of the storm, the stock
market notably fell down. Since it is possible that the price of the shares once more increase
even more than before in the near future, Ashley Swenson, chief financial officer (CFO) of
Gainesboro Machine Tools Corporation has the dilemma to buy back stock or to spend the
money as dividend the shareholders. In fact, the question is: How can she forecast the fortune
of the stock market? In the other word, what are the driving forces (as the external factors)
which are affecting on internal factors such as dividend policy? Definitely, the best way is to use
from Fuzzy Delphi Method (FDM). To perceive FDM, please review my article of “Fuzzy Delphi
Method to Design a Strategic Plan” on link” http://emfps.blogspot.com/2012/02/fuzzy-delphimethod-to-design-strategic.html”.
At the first, she can design a strategic plan including current and future BCG matrix. I think that
one of the best reference books which has established a logical relationship between BCG
matrix and Dividend policy is: “Corporate Financial Strategy” by Ruth Bender and Keith Ward
(Elsevier Butterworth-Heinemann)”. I would like to refer you page 34 (please review STEADY
STATE), page 59 (Balancing business and financial risk), page 75 (Figure 4.14), page 226
(Dividends and buybacks) on 3rd edition (2009). Where is the location of the firm in BCG
matrix? Stars (Growth), Question marks (Launch), Cash cows (Maturity) or Dogs (Decline).
Accordingto this reference book, we have below conditions for each area of BCG matrix:
Stars (Growth)
Question marks (Launch)
Business risk high
Business risk very high
Financial risk low
Financial risk very low
Funding equity
Funding equity
Nominal dividend payout ratio
Cash cows (Maturity)
Nil dividend payout ratio
Dogs (Decline)
Business risk medium
Business risk low
Financial risk medium
Financial risk high
Funding debt
Funding debt
High dividend payout ratio
Total dividend payout ratio
Let me specify the situation of this company on BCG matrix by using of its market share in
industry and industry revenue growth rate as follows:
-Referring to Exhibit 6, Gainesboro’s market cap is $ 504,000,000 in 2005 in which we can
calculate its share market approximately 1.43% (Please see my spreadsheet).
-Referring to Exhibit 2, the economic indicators show us the high growth rate of
macroeconomic environment in USA from 2001 to 2004 while the projected data present us a
steady and slow economic growth rate. On the other hand, if we see Exhibit 7, we will find that
the expected growth rate of sales (next 3-5 years) for high dividend payout companies is going
down whereas the zero-payout companies will have the high growth rate of sales.
We can observe this fact on consolidated Income Statement of Gainesboro (Exhibit 1) where
the negative growth rate from 2002 to 2004 accompanied by dividend payout has pushed the
current situation of this company on Quadrant IV of BCG matrix which is named Dogs. It means
that the current strategies of Gainesboro could be Retrenchment, Divestiture, and Liquidation.
Referring to the case, if Gainesboro diversifies its business units and products such as the
Artificial Workforce products, the expected growth rate of sales will go up 15% annually.
In this case, the new situation of company will be on Quadrant I of the BCG matrix (Question
Marks) where the dividend policy of this company should be Zero – dividend payout.
Here, I would like to bring you so many logical reasons which approve the Zero – dividend
payout as the best option for dividend policy of Gainesboro as follows:
1) Gainesboro has Negative Net Cash Flow. I calculated them in accordance with Exhibit 2
(please see my spreadsheet) below cited:
-Net Cash Flow in 2004 = -78376 (dollars in thousands)
-Net Cash Flow in 2005 (projected) = -36438 (dollars in thousands)
If you see Figure (4.10) on above reference book, you will find that the best dividend policy for
Gainesboro is nil dividend payout ratios.
2) Please compare Exhibit 1 with Exhibit 5 just like below table:
Year
Net income ($000)
Ave. Stock Price
2002
-$61,322
$26.45
2003
$12,993
$61.33
2004
-$140,784
$29.15
$18,018
?
2005 (Projected)
What can you consider instead of question mark? Definitely Gainesboro’s stock price will
significantly increase if the management prediction about the revenue growth rate is true.
Therefore, the best strategy is to repurchase Gainesboro’s shares.
3) Firstly, let me have an overview on all theories of dividend policy as follows:
-Dividend Relevance Theories
-Dividend Irrelevance Theories
Dividend Relevance Theory
A) Traditional Model
B) Walter’s Model
C) Gordon’s Dividend Capitalization Model
D) Bird-in-hand Theory
E) Dividend Signaling Theory
F) Agency Cost Theory
Dividend Irrelevance Theories
G) Residual Theory
H) Modigliani and Miller (M&M) Model
I) Dividend Clientele Effect
J) Rational Expectations Model
In the next article, I will examine each one of above models to find out the best dividend policy
for Gainesboro.
https://emfps.blogspot.com/2012/04/case-analysis-of-gainesboromachine.html
Case Analysis of GAINESBORO MACHINE TOOLS CORPORATION
Introduction
Following to the article of “Application of Pascal’s Triangular in Corporate Financial Strategy”
on link: http://emfps.blogspot.com/2012/04/application-of-pascals-triangular-in.html and the
article of “Case Analysis of GAINESBORO MACHINE TOOLS CORPORATION: The Dividend
Policy” on link: http://emfps.blogspot.com/2012/03/case-analysis-of-gainesboro-machine.html
In this article, I am willing to introduce you a new financial simulation model which is based on
EXHIBIT 8 (Projected Sources – and Uses Statement Assuming a 40% Payout Ratio) of the
case: GAINESBORO MACHINE TOOLS CORPORATION. In fact, the template of this new
simulation model is EXHIBIT 8 whereas I have developed this template by adding new
assumptions and new components. I can say that this simulation model is the combination of
Exhibit 8 and Discounted Cash Flow Analysis plus some new components. The purpose of this
simulation model is to analyze simultaneous impact two independent variables which are the
Cost of Capital (WACC) and Dividend payout ratio on one dependent variable which is the Stock
Price. My final result will be to find the appropriate the Cost of Capital (WACC) and Terminal
Value Growth Rate for two given data in this case which are dividend payout ratio and the Stock
Price. Of course, maybe you think that I should depict dividend policy which is the issue of the
case. Yes, but I will analyze it in my next article. Here, I will show you that I have still the
problem with the calculation WACC of Gainesboro Machine Tools Corporation. Anyway, I think
that I have obtained the best estimation for WACC.
Methodology
As I told you, I used from EXHIBIT 8 as my template and I entered all data on my spreadsheet
then I did following actions step by step:
Step1: I added below assumptions to Exhibit 8:
Ø Depreciation growth rate
Ø CAPEX growth rate
Ø Change in NWC growth rate
Ø Cost of Capital
Ø Terminal value growth rate
In the result, we will have 8 independent variables.
Step 2: To complete my spreadsheet (template), I should get the growth rate of CAPEX and
Change in NWC and Depreciation growth rate.
Firstly, I checked the amounts obtained from Exhibit 2 (Balance sheet) for CAPEX and Change in
NWC replaced on Exhibit 8 for 2005 year.
Note (1): I can tell you that Change in NWC (19.5) on Exhibit 8 is not true because we cannot
consider Bank loan as current liability. In the meanwhile, the growth rate of CAPEX for 2009
year had been considered 3.5%!!!!
Please see my true and false calculation as follows:
On the other hand, I calculated CAPEX as follows:
You can see on Exhibit 8 the amount of CAPEX is equal to 43.8 (2005 year) while the true
CAPEX is equal 39.63
I could not find any rational reason behind a 10.5 % increase on CAPEX.
Anyway, if you have any time, you can contact to writers (Robert F. Bruner and Sean Carr) or
publisher (University of Virginia Darden School Foundation, Charlottesville, VA) about these
problems.
Step 3: Following to step 2, I worked on the calculation of the cost of capital and terminal value
growth rate as follows:
Ø Cost of Debt
I considered the cost of debt equal to 4.3% in the reference with Exhibit 3 and Ten – year
Treasury note yield of 2004 year.
Ø Cost of Equity
The analysis of the cost of equity in this case is very hard. I use from three methods as follows:
1) Cost of Equity by using the Constant - Growth Valuation (Gordon) Model. Since the cost of
equity by using of this method is calculated approximately equal to 1.34% which is less than the
cost of debt, I assumed the cost of equity more than 4.3%.
2) Using of Stock valuation formula. This method is wrong way
3) The compare shareholders' expected return and cost of debt. In this method,
I assumed that the cost of equity is always less than the shareholders' expected return
and more than the cost of debt consequently we have 23% < Ke < 4.3%. I considered
the average of it as the cost of equity equal to 13%.
Here is my details calculation:
As you can see, finally I considered a range between 4% and 11% for WACC.
One of the most crucial problems to use the discounted cash flow analysis is to find the
appropriate the Terminal Value Growth Rate because this methodology is very sensitive to
TVGR. There are many ways to estimate TVGR as follows:
-Historic growth rates
-Forecast 3- year growth rates
-Terminal capital expenditure
-Competitive advantages among the firms
-Current and future market cap (refer to BGC matrix in Strategic Management)
-Porter’s five forces such as competitions on barriers to entry
-Macroeconomic indicators such as inflation, interest rate, GDP and so on
The based on Exhibit 3 and the growth rate of CAPEX for final cash flow, I assumed the range
between 0 and 3 for Terminal Value Growth Rate.
Step 4: I have added some components to my simulation model as follows:
-After dividend Excess cash
-Terminal value
-Total excess cash(borrowing )
-Plug: excess cash(borrowing)
-Present value of flows
-Enterprise value
-Borrowing needs
-FV of borrowing needs
-Plug: FV of borrowing needs
-New borrowing needs
- Current outstanding debt
-Total outstanding debt
-Equity value
-Current shares outstanding
-Equity value per share
-Current share price
I used from formula = IF (PLUG < 0, - PLUG, 0) and =IF (PLUG > 0, +PLUG, 0) for below
parameters:
-Plug: excess cash (borrowing)
-Borrowing needs
-Plug: FV of borrowing needs
Here is this part of my simulation model:
Note (2): I think this part of my simulation model is very important for Macroeconomic
analysis because we can examine the risk of deficit financing where the final cash flow will
lead us to a NPV > 0 or a huge economic collapse throughout the world.
Step 5: In this step, I used two ways table of sensitivity analysis in which I analyzed the impact
of the cost of capital and dividend payout ratio as independent variables on the stock price as
dependent variable. The findings are below cited.
Finding and Discussion
The final result of my sensitivity analysis is as follows:
In the reference with Exhibit 5, the average current stock price of Gainesboro Machine Tools
Corporation is equal $29.15
As you can see on above sensitivity analysis, there are four points which show us the current
situation of Gainesboro as follows:
-WACC = 5% and Dividend payout ratio = 35%
-WACC = 7% and Dividend payout ratio = 20%
- WACC = 9% and Dividend payout ratio = 5%
- WACC = 9% and Dividend payout ratio = 3%
In this analysis, I chose Terminal Value Growth rate equal to 3%.
Now, please look at Exhibit 1 (Income statement). You can see the dividend payout ratio for
2003 year is equal 35.7%
Dividend payout ratio = Total dividend payout / Net income
Total dividend payout = 0.25 * 18,600,000 = $4,650,000
Net income = 12,993 * 1000 = $12,993,000
Dividend payout ratio = (4,650,000 / 12,993,000) *100 = 35.7%
In the result, I can reserve my assumptions for Terminal Value Growth Rate = 3% and Cost of
Capital = 5 % as my primary data because of current situation of Gainesboro. As the matter of
fact, in my next article, I will explain you how we can make decision for dividend payout ratio
(Dividend Policy) where the basic of our assumptions for WACC will be equal 5 % and Terminal
value growth rate will be equal 3%.
Note: “All spreadsheets and calculation notes are available. The people, who are interested in having
my spreadsheets of this case analysis as a template for further practice, do not hesitate to ask me by
sending an email to: soleimani_gh@hotmail.com or call me on my mobile: +989109250225. Please be
informed these spreadsheets are not free of charge.”