Gainesboro Machine Tools Corporation

Different views on dividend policies

The amount of dividends paid out by firms has decreased sharply since 1978 when
66.5% firms used to payout dividends while the number has decreased to 20.7% in
1998. The reason behind this change is the tendency of most publicly owned firms
toward the characteristics of firms that never paid dividends (Fama and French
2001).
Firms have long-run targets for dividend payouts. Managers tend to keep a steady
progression in dividend payout ratio to avoid it being affected by temporary variations
in earnings. Markets are very sensitive to dividend cuts (Lintner 1956).
Dividend policy is irrelevant because the total effect of dividend payout and capital
loss is 0. Investors can generate funds by selling shares which have increased in
value if the company does not payout dividends. The firm should undertake all
projects that offer a positive NPV and pay as a dividend only unused fund (Miller and
Modigliani* 1961).
Zero- dividend payout
Pros:
       The company is growing and it needs to reinvest all earnings to
implement its goals of expansion.
       It would resolve the company’s problem of cash since it would not need
to borrow.
       7 out of 8 CAD/CAM companies were not paying any dividends although
they were all expecting significant growth of their business. On the other
hand, electrical-industrial or tool manufacturers were paying up to a 3.1 yield
on shares (Exhibit 6). A zero-dividend payout policy would help the firm`s
brand image to be seen by investors as a hi-tech software/hardware
company rather than a traditional manufacturer in accordance to the
company`s goals.
       The dividend tax would be avoided (the gain in capital value is not
taxed).
Cons:
       Managers would lose their credibility since they have already promised
to re-instate dividend payout during the year.
       Clientele effect: Many investors would be disappointed by the change in
dividend policy and might sell short causing a drop in share prices.
       Information signalling: Markets may take it as a negative signal
reinforcing the idea that the company is experiencing problems.
This policy is supported by the study from Fama and French (2001).
 
 
 
*Now on it would be referred to as “MM”.

40 percent dividend payout ($0.20 a share)

 
                  Pros
 
       Information signalling: Investors would interpret it as a positive
sign that the company is doing well and has overcome its difficulties.
       The company would still be under the 40% debt-to-equity ratio
limit (Exhibit 1).
       Managers’ credibility would increase as they were loyal to their
promised preannounced dividend payout.
 
                  Cons
 
       The company would need to raise funding. Board members
would not appreciate such a sudden increase in debts although within
the set limits.
       The 15% growth prediction is the most optimistic approach and
leaves no room for flexibility. In case something does not go according
to the predictions, the company would experience serious problems.
       The payout ratio would be in-line with other traditional
manufacturers’ (not hi-tech) dividend policy such harming the image of
the company.
       There would be losses from the tax on dividends.
 
This policy is supported by the study of Lintner (1956).
 
Residual- Dividend payout
 
                  Pros
 
                  The company would maximise its value by accepting all
projects that have a positive NPV.
                  There would be no liquidity problems and the company
would not need to increase its equity-to-debt ratio.
 
                  Cons
 
                  The clientele effect: there would be no clear dividend
policy and as a result few or no new investors would be attracted.
Also existing ones might like to invest their funds somewhere else
where a steady return is guaranteed.
                   Information signalling: The company image might be
damaged. This policy might suggest investors that the company is
going through an insecure period.
 
This policy is supported by the study of MM.
 
Funding
A company might choose to finance its activities either by debt or by equity. There
are two main views about the way a firm should manage its capital structure. The
traditional view supports the idea that debt is cheaper than equity because equity is
more risky. The market value of a firm is given by: Equity + Debt = E + D = V which
implies that the cost of capital can be reduced by substituting debt with equity. When
D/E ratio is too high, both ordinary shareholders and lenders would need additional
returns in order to compensate them for the increasing risks. The view states that
there exists a point where the cost of capital can be minimised by a debt/equity mix
which would achieve an optimal capital structure (Atrill 2003).
On the other hand, MM offered a different view. They argued that the only difference
between debt and equity is taxation and as a result the firm should finance itself only
with debt to lower its cost of capital.
Implications for the shareholders.

       Borrowing
Agency Theory: Although it might be cheaper, shareholders are not very keen to
increase very much the company`s exposure to loan debt as they prefer to use its
own resources. Although not efficient, this attitude is still strong at management
level.

       Issuing new shares

Shareholders tend not to like the new issue of shares since they lose control over the
company as the number of investors increases. New investors might impose
conditions using their voting rights to change policies etc. (Arnold 2007).

       Decrease investments

The current investments with help the company grow in both volume and value. This
means that none from the important groups of shareholders would support a
decrease in investments.
Implication for the company

       Borrowing
It will be in the company`s interest to increase the amount of loan debts because it is
cheaper than equity debts. Both the traditional and MM views support this in lower
levels of the debt/equity ratio. In this particular case though, this might not be true
because  the usage of the loan to pay shareholders would be considered as a risky
activity by the bank and as a result it would ask for a higher interest rate.
        Issuing new shares
The advantages of issuing shares as a mean of financing would include the shares’
acting as a shock absorber, meaning that in the event of losses the company is able
to decrease paid out dividends at any time. Also, shares have no redemption date to
be paid off such helping the cash flow of the company. On the other hand issuing
shares brings two types of additional costs. Administrative and legal costs and an
additional premium requested by investors since they are the last being liquidated in
case of bankruptcy (Arnold, 2007).

       Decrease investments

The company is very dependent on the increase in system applications, system
improvements and international expansion so reducing investments at this point
might prove fatal to the company’s sales and market share due to the increasing
competition in the sector.
Reaction of the shareholders to dividend payout
All shareholders would appreciate the news about dividend payout. Some of them
need it as a steady income source (Exhibit 4) and others might use it to re-invest it in
the company by buying shares. Outside investors might see this as a positive sign
that the company is doing good and as a result the price of the shares will increase.
The two effects (shares buyback and price increase) might not be equal. In addition,
this might be seen as a promise of the company to pay dividends regularly and
interested investors that would like a non-volatile return on their assets would be
interested to invest in the company.
Lenders do not consider it safe to provide funds for a company which will use them
to payout its shareholders. As a result they might ask a higher interest rate to be paid
(Arnold 2007). On the other hand there is evidence that share purchase is taken as a
positive signal from investors and this might increase further the market share price
(Atrill 2003).
Repurchase of shares
Shareholders would prefer a buyback because in this way they would either see their
share prices increase in value (if they didn`t sell) or they can enjoy the return coming
from the positive difference in buying their shares cheap and selling  high (Urry
2004).
As mentioned above, lenders would not finance a repurchase of shares for
shareholders wealth, unless a higher cost is paid for the loan because they would
see the company as risky and as an attempt from her part to deceivably give positive
signals to the market since repurchase of shares is a characteristic of companies
with surplus amounts of cash.  This higher cost could remove the advantage of
minimising the capital cost by debt (Brealey et.al. 2006).
Recommendations

       Dividend payout

The first recommendation would be to declare a dividend payout in order to boost the
confidence in the company which has been weakened in these last years. The 40%
payout seems too risky though because it leaves no room for flexibility and it would
cause the company to continue suffering losses until 2011. Since the company is
expected to grow at a 15% rate than the payout could be anywhere between 30%
and 50%. Declaring a dividend of 30% would solve all problems. It would reinstate
the confidence in the company and would still leave room for financial flexibility if the
markets do not behave as predicted.
Remaking the calculations for a 30% dividend payout the company could become
profitable at both 2009 and 2011 reducing its loss $53.69 mln (See Apendix 1). In
time, the company can continue increasing the dividend payout at a slow rate up to
40% if the predictions are right.

       Financing
The company would be able to borrow only at high rates from banks if the funding
was to be used for dividend payout. On the other hand, shareholders might not
approve an issue of ordinary shares since they might lose control over the company
in this case.
 
 
To avoid these problems the CEO might propose to issue new shares in two
categories. First, to avoid the dilution of power, shares would be offered to existing
shareholders (right issues). If existing shareholders would not be able or willing to
raise the needed amount than a second round of shares would be issued to external
investors. These shares should be preferential in order to avoid the equity risk (which
makes this kind of financing more expensive) and hold one or some of the following
features according to their costs:
o       No voting rights. This is the usual form of preferential shares (Arnold
2007) and avoids the problem of power dilution.
o       Redeemable. The company might like to have this option in order to buy
back these shares if and whenever it does not need these funds any longer.
Since the company is rated as “A” by Value Line the issuing cost will most likely be
lower than most competitors. Issuing new shares would also improve the debt-to-
equity ratio leaving open the opportunity to take loans for expansion purposes in the
future.
 
 
 
References
Arnold, G. (2007) Corporate Financial Management, 4 Ed., FT Prentice Hall,
th

Harlow.
 
Atrill, P. (2003) Financial Management for Non-specialist, 3 Ed., FT Prentice Hall,
rd

Harlow.
 
Brealey, R.A., Myers, S.C. & Allen, F. (2006) Principles of Corporate Finance, 8 Ed.,
th

McGraw-Hill, NY: N.Y.

 
Fama, E & K. French (2001) “Disappearing dividends: Changing firm characteristics
or lower propensity to pay?”, Journal of Financial Economics, 60(1), pp.3-43.
 
Lintner, J. (1956) “Distribution of incomes of corporations among dividends, retained
earnings and taxes”, American Economic Review, Vol. 46(2), pp. 97-113.
 
Miller, M.H. & Modigliani, F. (1961) “Dividend policy, growth and the valuation of
shares”, Journal of Business, Vol. 34 (4), pp. 411-433.
 
Urry. M. (2004) “The dilemma of how best to share wealth”, FT, 17/18 July, p.M21.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Appendix 1.
 
  2005 2006 2007 2008 2009 2010 2011 2005-
2011
Net Income 18.10 40.00 57.50 72.80 91.3 98.00 160.00 537.8
Excess Cash -22.70 -7.30 4.20 11.50 29.4 27.20 77.60 120.0
Dividend 5.43 12.00 17.25 21.84 27.39 29.40 48.00 161.31
Excess cash -28.13 -19.30 -13.05 -10.34 2.01 -2.20 29.60 -41.41
after dividend
 
Note: Dividend calculated as 30% of income.