Sunday, March 25, 2012

Case Analysis of GAINESBORO MACHINE TOOLS CORPORATION: The Dividend Policy


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-delphi-method-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                                   Nil dividend payout ratio

Cash cows (Maturity)                                                       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
2005 (Projected)                   $18,018                              ?
 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. 


 
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 cellphone: +989109250225.   Please be informed these spreadsheets are not free of charge.”
 
To be continued …….