GAINESBORO MACHINE TOOLS CORPORATION
Ashley Swenson, CFO of Gainesboro Machine Tools Corporation (GMT), had to recommend an effective dividend policy at a down time of GMT stock price’s performance. She needed either to recommend to payout cash dividend or to buyback shares from its shareholders. Also, if any, the percentage of dividend payout has to be determined. Opinions about those recommendations were separated among board members and managers. At that time, a payout policy for GMT was needed in urgent manner.
Choice 1: Cash Dividend Payout
If Ashely recommended a policy of paying out cash dividend, she also had to decide the percentage of earnings GMT has to payout as dividend. Different level of dividend payout policy has different effect reflected on the following stock price. Ashely could choose from three options: a zero-dividend payout, a 40%-dividend payout, or a residual-dividend payout.
By retaining all the capital inside GMT the company itself, this dividend policy justified the firm’s business emphasis on the advanced technologies and Computer Automatic Design/ Computer Automatic Manufacture(CAD/CAM) machines. If there was no dividends payout, then GMT could use all the earnings generated during the year to fund its high-cash-requirements growth and its entrance into new business areas. However, shareholders of GMT, those whose initial investment motivation was investment profits, might lose confidence in the firm’s future because of the fact that they might consider a zero-dividend policy as a negative signal that GMT could not generate extra money or earn profits. Loss of confidence from investors could be obsolutely devastating for GMT at a time of gloomy stock performance.
40% dividend payout or a dividend of around $0.20 a share
This 40% dividend-payout policy stood in the same line as the industry payout standards. A dividend of 40% would absolutely show interior confidence about GMT’s future growth. This meaned that the company not only make extra money during the year but also has money to support its own expansion needs. However, this 40% policy would also limit the availability of cash for reinvestment in the future and the flexibility of management to choose projects to invest. Another thing worth attention is that the assumption of a 15% growth rate might be overly optimistic for GMT. The projections of 2005 would have a debt equity ratio of 35%1 with a 40% dividend payout. Although the firm still had some debt capacity, but 5% flexibility of debt might be too risky in terms of the firm’s future business strategy2 or financing needs.
Residual dividend payout
A residual dividend policy would allow the firm to pay dividends only after all projects with positive NPVs were financed. Indeed, increased debt needs might be limited, and investors’ confidence might be built. However, dividends payout would become fluctuated and thus unpredictable to investors. Fluctuation in dividend might become fluctuation in investors’ perspective or confidence for the firm’s future development, which would put more pressure on the already weak share price. Considering the current GMT stock performance, a residual dividend policy was not recommended mostly because of the impact of its uncertain cashflow to investors’ confidence.
Choice 2: Share Buyback
There is no doubt that this policy would get confidence from the market by