eastboro case solution

The general problem in this case is modeled upon a much older case by Robert F. Vandell and Pearson Hunt, which has been out of print for a number of years. It was believed that students today would benefit from a problem like that, but with a broader set of policy issues cast in a contemporary setting. Despite numerous differences in form and substance between the earlier case and this, the debt to Vandell and Hunt remains large. Vandell was a gracious colleague and mentor to the authors, who hope this work is a respectful memorial to him. Vandell and Hunt produced no teaching note for their case. Our understanding of the Vandell-Hunt case was assisted greatly by notes and comments from our colleague Professor William W. Sihler, who edited the older case and reviewed this one. The original version of this case was prepared by Casey Opitz under the direction of Robert F. Bruner. This teaching note was written by Robert F. Bruner. Copyright © 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

Case 24 Version 1.1

Eastboro Machine Tools Corporation

Teaching Note Synopsis and Objectives

In mid-September 2001, Jennifer Campbell, the chief financial officer of this large CAD/CAM (computer-aided design and manufacturing) equipment manufacturer must decide whether to pay out dividends to the firm�s shareholders, or repurchase stock. If Campbell chooses to pay out dividends, she must also decide on the magnitude of the payout. A subsidiary question is whether the firm should embark on a campaign of corporate-image advertising, and change its corporate name to reflect its new outlook. The case serves as an omnibus review of the many practical aspects of the dividend and share buyback decisions, including (1) signaling effects, (2) clientele effects, and (3) finance and investment implications of increasing dividend payout and share repurchase decisions. This case can follow a treatment of the Miller-Modigliani1 dividend-irrelevance theorem and serves to highlight practical considerations in setting dividend policy.

1Merton Miller and Franco Modigliani, �Dividend Policy, Growth, and the Valuation of Shares,� Journal of Business

34 (October 1961): 411-33.

Other cases in which dividend policy is an important issue: �Deutsche Brauerei� (case 10).

Suggested Questions for Advance Assignment to Students

The instructor could assign supplemental reading on dividend policy and share repurchases. Especially recommended are the Asquith and Mullins article2 on equity signaling, and articles by Stern Stewart on financial communication.3

1. In theory, to fund an increased dividend payout or a stock buyback, a firm might invest less,

borrow more, or issue more stock. Which of these three elements is Eastboro management willing to vary, and which elements remain fixed as a matter of policy?

2. What happens to Eastboro�s financing need and unused debt capacity if

a. no dividends are paid? b. a 20 percent payout is pursued? c. a 40 percent payout is pursued? d. a residual payout policy is pursued?

Note that case Exhibit 8 presents an estimate of the amount of borrowing needed. Assume that maximum debt capacity is, as a matter of policy, 40 percent of book value of equity.

3. How might Eastboro�s various providers of capital, such as stockholders and creditors, react

if Eastboro declares a dividend in 2001? What are the arguments for and against the zero payout, 40 percent payout, and residual payout policies? What should Jennifer Campbell recommend to the board of directors with regard to a long-run dividend payout policy for Eastboro Machine Tools Corporation?

4. How might various providers of capital, such as stockholders and creditors, react if Eastboro

repurchased shares? Should Eastboro do so?

5. Should Campbell recommend the corporate-image advertising campaign and corporate name change to the directors? Do the advertising and name change have any bearing on the dividend policy or stock repurchase policy you propose?

Supporting Computer Spreadsheet Diskfiles

For students: UVA-S-F-1360.XLS For instructors: UVA-S-F-1360TN.XLS

2Paul Asquith and David W. Mullins, Jr., �Signaling with Dividends, Stock Repurchases, and Equity Issues,�

Financial Management (Autumn 1986): 27-44. 3See �How to Communicate with an Efficient Market� and �A Discussion of Corporate Financial Communication� in

Midland Corporate Finance Journal 2 (Spring 1984).

Hypothetical Teaching Plan

1. What are the problems here, and what do you recommend?

The CFO needs to resolve the issue of dividend payout in order to make a recommendation to the board. She must also decide whether to embark on a stock repurchase program given the sharp drop in share prices. Nominally, the problems entail setting dividend policy, deciding on a stock buyback, and resolving the image-advertising campaign issue. But numerical analysis of the case shows the �problem� includes other factors: setting policy within a financing constraint, signaling the directors� outlook, and generally, positioning the firm�s shares in the equity market.

2. What are the implications of different payout levels for Eastboro’s capital structure and unused debt capacity?

The discussion here must present the financial implications of high dividend payouts, particularly the consumption of unused debt capacity. Because of the cyclicality of demand or overruns in investment spending, some attention might be given to a sensitivity analysis over the entire 2001-07 period.

3. What is the nature of the dividend decision Campbell must make, and what are the pros and

cons of the alternative positions? (Or alternatively, Why pay any dividends?) How will Eastboro’s various providers of capital, such as stockholders and bankers, react to a declaration of no dividend? Of a 40 percent payout? Of a “residual” payout?

The instructor needs to elicit the notions that the dividend-payout announcement may affect stock price and that at least some stockholders prefer dividends. The signaling and clientele considerations must also be raised.

4. What risks does the firm face?

Discussion following this question should address the nature of the industry, the strategy of the firm, and the firm�s performance. This discussion will lay the groundwork for the review of strategic considerations that bear on the dividend decision.

5. What is the nature of the share repurchase decision Campbell must make and how would this affect the dividend decision? The discussion here must present the repercussions of a share repurchase decision on the share price, as well as on the dividend question. Signaling and clientele considerations must also be considered.

6. Does the stock market appear to reward high dividend payout? Low dividend payout? Does it matter what type of investor owns the shares? What is the impact of dividend policy on share price?

The data can be interpreted to support either view. The point is to show that simple extrapolations from stock-market data are untrustworthy, largely because of econometric problems associated with size and omitted variables (see the Black and Scholes article).4

7. What should Campbell recommend?

Students must synthesize a course of action from the many facts and considerations raised. The instructor may choose to stimulate the discussion by using an organizing framework such as FRICT (flexibility, risk, income, control, and timing) on the dividend and share repurchase issues. The image advertising and name-change issue will be recognized as another manifestation of the firm�s positioning in the capital markets, and the need to give effective signals. The class discussion can end with a vote on the alternatives, followed by a summary of key

points. Exhibits TN1 and TN2 contain two short technical notes on dividend policy, which the instructor may either use as the foundation for closing comments or distribute directly to the students after the case discussion. Case Analysis

Eastboro’s asset needs

The company�s investment spending and financing requirements are driven by ambitious growth goals (a 15 percent annual target is discussed in the case), which are to be achieved by a repositioning of the firm�away from its traditional tools-and-molds business and beyond its CAD/CAM business into a new line of products integrating hardware and software�to provide complete manufacturing systems. CAD/CAM commanded 45 percent of total sales ($340.5 million) in 2000 and is to grow to three-quarters of sales ($1,509.5 million) by 2007, which implies a 24 percent annual rate of growth in this business segment over the subsequent seven years. In addition, international sales are expected to grow by 37 percent compounded over the subsequent seven years.5 By contrast, the presses-and-molds segment will grow at about 2.7 percent annually in nominal terms, which implies a negative

4Fisher Black and Myron Scholes, �The Effects of Dividend Yield and Dividend Policy on Common-Stock Prices

and Returns,� Journal of Financial Economics 1 (1974): 1-22. 5International sales accounted for 15 percent ($114 million) in 2000. They are expected to account for one-half of

all sales by 2007 (about $1 billion).

Discussion Question 2

real rate of growth in what constitutes the bulk of Eastboro�s current business.6 In short, the company�s asset needs are driven primarily by a shift in the strategic focus of the company.

Financial implications of payout alternatives The instructor can guide the students through the financial implications of

various dividend-payout levels either in abbreviated form (for a one-period class) or in detail (for a two-period class). The abbreviated approach uses the total cash-flow figures (i.e., for 2001-07) found in the right-hand column of case Exhibit 8. In essence, the approach uses the basic sources and uses of funds identity: Asset change = New debt + (Profits - Dividends)

With asset additions fixed largely by the firm�s competitive strategy, and with profits determined largely by the firm�s operating strategy and the environment, the remaining large decision variables are (1) changes in debt and (2) dividend payout. Even additions to debt are constrained, however, by the firm�s maximum leverage target, a debt/equity ratio of .40. This framework can be spelled out for the students to help them envision the financial context.

Exhibit TN3 presents an analysis of the effect of payout on unused debt capacity based on

the projection in case Exhibit 8. The top panel summarizes the firm�s investment program over the forecast period, as well as financing provided from internal sources. The bottom panel summarizes the effect of higher payouts on the firm�s financing and unused debt capacity. The principal insight this analysis yields is that the firm�s unused debt capacity disappears rapidly, and maximum leverage is achieved as the payout increases. Going from 20 to 40 percent dividend payout (an increase in cash flow to shareholders of $95 million),7 the company consumes $134 million in unused debt capacity. Evidently, a multiplier relationship exists between payout and unused debt capacity�every dollar of dividends paid consumes about $1.408 of debt capacity. The multiplier exists because a dollar must be borrowed to replace each dollar of equity paid out in dividends, and each dollar of equity lost sacrifices $.40 of debt capacity that it would have carried.

Whereas the abbreviated approach to analyzing the implications of various dividend-payout levels considers total 2001-07 cash flows, the detailed approach considers the pattern of the individual annual cash flows. Exhibit TN4 reveals that, although the debt/equity ratio associated with the 40 percent payout policy is well under the maximum of 40 in 2007, the maximum is

6Presses and molds accounted for 55 percent of sales ($416 million) in 2000. By 2007, this segment will account for

about one-quarter of sales ($503 million). The implied compound annual growth rate of 2.7 percent is below the projected 3-month Treasury bill rates given in case Exhibit 3, suggesting that the real rate of growth in this segment is below zero.

7The change in cash flow to shareholders is equal to the difference between dividends paid under the 40 percent policy ($215 million) and the dividends ($107) and stock buy-back ($12) under the 20 percent policy.

8Unused debt capacity of $134 ÷ additional dividends paid of $95 results in a ratio of about 1.4.


breached in the preceding years. The graph suggests that a payout policy of 30 percent is about the maximum that does not breach the debt/equity maximum.

Exhibits TN5 and TN6 reveal some of the financial-reporting and valuation implications of

alternative dividend policies. These exhibits use a simple dividend valuation approach and assume a terminal value estimated as a multiple of earnings. The analysis is unscientific, as the case does not contain the information with which to estimate a discount rate based on CAPM.9 The DCF values show that the firm is slightly more valuable at lower payouts�this is because of the positive impact on EPS of lower interest costs. However, a better inference would be that the differences are not that large and that the dividend policy choice in this case has little effect on value. This conclusion is consistent with the Miller-Modigliani dividend irrelevance theorem.

Regarding the financial-reporting effects of the policy choices, one sees that earnings per share (line 31) and the implied stock price (line 32) grow more slowly at a 40 percent payout policy because of the greater interest expense associated with higher leverage (see line 23). Return on average equity (line 29) rises with higher leverage, however, as the equity base contracts. The instructor could use insights such as these to stimulate a discussion of signaling consequences of the alternative policies, and whether investors even care about performance measures such as EPS and ROE.10

Risk assessment

Neither the abbreviated nor detailed forecasts consider adverse deviations from the plan. Case Exhibit 8 assumes no cyclical downturn over the seven-year forecast period. Moreover, the model assumes that net margin doubles to 5 percent and then increases to 8 percent. The company may be able to rationalize these optimistic assumptions on the basis of its restructuring and the growth of the Artificial Workforce, but such a material discontinuity in the firm�s performance will warrant careful scrutiny. Moreover, continued growth may require new-product development after 2002, which may incur significant research-and-development expenses and reduce net margin.

Students will point out that, so far, the company�s restructuring strategy is associated with losses (in 1998 and 2000) rather than gains. Although restructuring appears to have been necessary, the credibility of the forecasts depends on the assessment of management�s ability to begin harvesting potential profits. Plainly, the Artificial Workforce has the competitive advantage at the moment, but the volatility of the firm�s performance in the current period is significant: the ratio of cost of goods sold to sales rose from 61.5 percent in 1999 to 65.9 percent in 2000. Meanwhile, the ratio of selling, general, and administrative expenses to sales is projected to fall from 30.5 percent in

9A discount rate of 12 percent is used for illustrative purposes. Presumably, the required return on equity would vary

with the leverage of the firm. 10These measures are subject to accounting manipulation and are therefore unreliable. However, many operating

executives believe that such measures still retain some influence over the type of equity investors that a firm attracts.


2000 to 24.3 percent in 2001. Admittedly, the restructuring accounts for some of this volatility, but the case suggests several sources of volatility that are external to the company: recession, currency, new-competitor entry, new-product foul-ups, cost overruns, and surprise acquisition opportunities.

A brief survey of risks invites students to perform a sensitivity analysis of the firm�s debt/equity ratio under a reasonable downside scenario. Students should be encouraged to exercise the associated computer spreadsheet model, making modifications as they see fit. Exhibit TN7 presents a forecast of financial results, assuming a net margin that is smaller than the preceding forecasts by 1 percent and sales growth at 12 percent rather than 15 percent. This exhibit also illustrates the implications of a residual dividend policy, i.e., the payment of a dividend only if the firm can afford it and if the payment will not cause the firm to violate its maximum debt ratios. The exhibit reveals that, in this adverse scenario, although a dividend payment would be made in 2001, none would be made in the next two years. Thereafter, the dividend payout would rise. The general insight remains that the unused debt capacity of Eastboro is relatively fragile and easily exhausted. The stock-buyback decision The decision on whether or not to buy back stock should be that, if the intrinsic value of Eastboro is greater than its current share price, the shares should be repurchased. The case does not provide the information needed to make free cash flow projections, but one can work around the problem by making some assumptions. The DCF calculation presented in Exhibit TN8 uses net income as a proxy for operating income,11 and assumes a WACC of 10 percent, and a terminal value growth factor of 3.5 percent. The equity value per share comes out to $35.72, representing a 61 percent premium over the current share price. Based on this calculation, Eastboro should repurchase shares! However, doing so will not solve Eastboro�s dividend/financing problem. Buying back shares would further reduce the resources available for a dividend payout. Also, a stock buyback may be inconsistent with the message Eastboro is trying to convey (i.e., that it is a growth company). In a perfectly efficient market, it should not matter how investors get their money back (e.g., through dividends or share repurchases), but in inefficient markets, the role of dividends and buybacks as signaling mechanisms cannot be disregarded. In Eastboro�s case, we seem to have the case of an inefficient market; the case suggests that information asymmetries exist between company insiders and the stock market.

Clientele and signaling considerations

The profile of Eastboro�s equity owners may influence the choice of dividend policy. Stephen East, the chair of the board and scion of the founders� families and management (who collectively own about 30 percent of the stock),

11This violates the rule that free cash flows should reflect prefinancing cash flows. However, we are not given

any operating income assumptions.



seeks to maximize growth in the market value of the company�s stock over time. This goal invites students to analyze the impact of dividend policy on valuation. Nevertheless, some students might point out that, as the population of diverse and disinterested heirs of East and Peterboro grows, the demand for current income might rise. This naturally raises the question, Who owns the firm? The stockholder data in case Exhibit 4 show a marked drift over the past 10 years: away from long-term individual investors and toward short-term traders; and away from growth-oriented institutional investors and toward value investors. At least a quarter of the firm�s shares are in the hands of investors who are looking for a turnaround in the not-too-distant future.12 This lends urgency to the dividend and signaling question.

The case indicates that the board committed itself to resuming a dividend as early as possible

��ideally in 2001.� The board�s letter charges this dividend decision with some heavy signaling implications: because the board previously stated a desire to pay dividends, if it now declares no dividend investors are bound to interpret the declaration as an indication of adversity. One is reminded of the Sherlock Holmes story �Silver Blaze,� in which Dr. Watson asks where to look for a clue:

�To the curious incident of the dog in the night-time,� says Holmes. �The dog did nothing in the night-time,� Watson answers. �That was the curious incident,� remarked Sherlock Holmes.13

A failure to signal a recovery might have an adverse impact on share price. In this context, a dividend�almost any dividend�might indicate to investors that the firm is prospering more or less according to plan.

Astute students will observe that a subtler signaling problem occurs in the case: what kind of firm does Eastboro want to signal that it is? Case Exhibit 6 shows that CAD/CAM equipment and software companies pay low or no dividends, in contrast to electrical machinery manufacturers, who pay out one quarter to as much as 60 percent of their earnings. One can argue that, as a result of its restructuring, Eastboro is making a transition from the latter to the former. If so, the issue becomes how to tell investors.

The article by Asquith and Mullins14 suggests that the most credible signal about corporate prospects is cash, in the form of either dividends or capital gains. Until the Artificial Workforce product line begins to deliver significant flows of cash, the share price is not likely to respond significantly. In addition, any decline in cash flow, caused by the risks listed earlier, would worsen the anticipated gain in share price. By implication, the Asquith-Mullins work would cast doubt on

12These �turnaround� investors probably include the value-oriented institutional investors (13 percent of shares) and

the short-term, trading-oriented individual investors (13 percent of shares). 13From The Memoirs of Sherlock Holmes by Sir Arthur Conan Doyle. 14Paul Asquith and David W. Mullins, Jr., �Signaling with Dividends, Stock Repurchases, and Equity Issues,�

Financial Management (Autumn 1986): 27-44.

corporate image advertising: if cash dividends are what matters, then spending on advertising and a name change might be wasted.

Stock prices and dividends

Some of the advocates of a high-dividend payout suggest that high stock prices are associated

with high payouts. Students may attempt to prove this point by abstracting from the evidence in case Exhibits 6 and 7. As we know from academic research (e.g., Friend and Puckett),15 proving the relationship of stock prices to dividend payouts in a scientific way is extremely difficult. In simple terms, the reason is because price/earnings (P/E) ratios are probably associated with many factors that may be represented by dividend payout in a regression model. The most important of these factors is the firm�s investment strategy; Miller and Modigliani�s16 dividend-irrelevance theorem makes the point that the firm�s investments�not the dividends it pays�determine stock prices. One can just as easily derive evidence of this assertion from case Exhibit 7. The sample of zero-payout companies has a higher average expected return on capital (13.6 percent) than the sample of high-payout companies (average expected return of 10.9 percent); one may conclude that zero-payout companies have higher returns than high-payout companies and that investors would rather reinvest with zero-payout companies than receive a cash payout and be forced to redeploy the capital to lower-yielding investments. Decision

The decision at hand is whether Eastboro should buy back stock or declare a dividend in the third quarter (although, for practical purposes, students will find themselves deciding for all of 2001). As the analysis so far suggests, the case draws students into a tug-of-war between financial considerations (which tend to reject dividends and buybacks, at least in the near term) and signaling considerations (which call for the resumption of dividends at some level, however small). Students will tend to cluster around three proposed policies: (1) zero payout, (2) low payout (1-10 percent), and (3) a residual payout scheme calling for dividends when cash is available.

The arguments in favor of zero payout are: (1) the firm is making the transition into the CAD/CAM industry, where zero payout is the mode; (2) the company should not ignore the financial statements and act like a blue-chip firm�Eastboro�s risks are large enough without compounding them by disgorging cash; and (3) the signaling damage already occurred when the directors suspended the dividend in 2001.

15Irwin Friend and M. Puckett, �Dividends and Stock Prices,� American Economic Review 54 (September 1964):

656-82. 16Merton Miller and Franco Modigliani, �Dividend Policy, Growth, and the Valuation of Shares,� Journal of

Business 34 (October 1961): 411-33.

Discussion Question 1 and Closing Vote

The arguments in favor of a low payout are usually based on optimism about the firm�s prospects and on beliefs that Eastboro has sufficient debt capacity, that Eastboro is not exactly a CAD/CAM firm, and that any dividend that does not restrict growth will enhance share prices. Usually, the signaling argument is most significant for the proponents of this policy.

The residual policy is a convenient alternative, although it resolves none of the thorny policy

issues in this case. A residual dividend policy is bound to create significant signaling problems as the firm�s dividend waxes and wanes through each economic cycle.

The question of the image advertising and corporate name change will entice the naive student as a relatively cheap solution to the signaling problem. The instructor should challenge such thinking. Signaling research suggests that effective signals are (1) unambiguous and (2) costly. The advertising and name change, costly as they may be, hardly qualify as unambiguous. On the other hand, seasoned investor relations professionals believe that advertising and name changes can be effective in alerting the capital markets to major corporate changes when integrated with other signaling devices such as dividends, capital structure, and investment announcements. The whole point of such campaigns should be to gain the attention of �lead steer� opinion leaders.

Overall, inexperienced students tend to dismiss the signaling considerations in this case quite readily; senior executives and seasoned financial executives, on the other hand, view signaling quite seriously. If the class votes to buy back stock or declare no dividend in 2001, asking some of the students to dictate a letter to shareholders explaining the board�s decision may be useful: the difficult issues of credibility will emerge in a critique of this letter.

If the class does vote to declare a dividend, the instructor can challenge the students to identify the operating policies they gambled on to make their decision. The underlying question: If adversity strikes, what will the class sacrifice first: debt, or dividend policies?

Dividend policy is �puzzling,� to use Fisher Black�s term, largely because of its interaction with other corporate policies and its signaling effect.17 Decisions about the firm�s dividend policy may be the best way to illustrate the importance of managers� judgments in corporate finance. However the class votes, one of the teaching points is that managers are paid to make difficult, even high-stakes policy choices on the basis of incomplete information and uncertain prospects.

17Fisher Black, �The Dividend Puzzle,� Journal of Portfolio Management (Winter 1976): 5-8.

Exhibit TN1 EASTBORO MACHINE TOOLS CORPORATION Supplemental Note: The Dividend Decision and Financing Policy

The dividend decision is necessarily part of the financing policy of the firm. The dividend payout chosen may affect the creditworthiness of the firm and hence the costs of debt and equity; if the cost of capital changes, so may the value of the firm. Unfortunately, one cannot determine whether the change in value will be positive or negative without knowing more about the optimality of the firm�s debt policy. The link between debt and dividend policies has received little attention in academic circles, largely because of its complexity, but remains an important issue for chief financial officers and their advisors. The Eastboro case illustrates the impact of dividend payout on creditworthiness.

Dividend payout has an unusual multiplier effect on financial reserves. The following table varies the total 2001-07 sources and uses of funds given in case Exhibit 8, according to different dividend-payout levels.

Remarks0% 20% 40% 50%

Net Profit 537.8$ 537.8$ 537.8$ 537.8$ Less dividends - 107.6 215.1 268.9 Earnings retained 537.8 430.2 322.7 268.9 New debt (stock buy-back) (119.3) (11.9) 95.5 149.2Depreciation 252.0 252.0 252.0 252.0 Increase in assets 670.5 670.3 670.2 670.1

Initial debt (2000) 80.3 80.3 80.3 80.3

Change in debt - - 95.5 149.2

Zero if (retained earnings + depreciation) >= increase in assets; otherwise the difference between (retained earnings + depreciation) and (increase in assets)

Ending debt (2007) 80.3 80.3 175.8 229.5

Initial equity (2000) 282.5 282.5 282.5 282.5 Earnings retained 537.8 430.2 322.7 268.9

Stock buyback (119.3) (11.9) - -

Zero if (retained earnings + depreciation) <= increase in assets; otherwise the difference between (retained earnings + depreciation) and (increase in assets)

Ending equity (2007) 701.0 700.9 605.2 551.4 Total capital 781.3 781.1 781.0 780.9

Debt/total capital 10.3% 10.3% 22.5% 29.4%Debt/equity 11.5% 11.5% 29.0% 41.6%

Debt capacity 280.4 280.3 242.1 220.6 (@.4=max debt/equity)Debt capacity used 80.3 80.3 175.8 229.5 Unused debt capacity 200.1 200.1 66.3 (8.9)

1.40 1.40 Incremental debt / incremental dividends and stock buybacks

Targeted Dividend Payout

Ratio of debt capacity used to incremental payments to shareholders

Exhibit TN1 (continued)

As the table reveals, one dollar of dividends paid consumes $1.40 in unused debt capacity. At first glance, this result seems surprising�under the sources-and-uses framework, one dollar of dividend is financed with only one dollar of borrowing. The sources-and-uses reasoning, however, ignores the erosion in the equity base: a dollar paid out of equity also eliminates $0.40 of debt that the dollar could have carried. Thus, a multiplier effect exists between dividends and unused debt capacity whenever a firm borrows to pay dividends.

The choice of dividend payout will affect the probability that the firm will breach its maximum target leverage. The following figure traces the debt/equity ratios associated with Eastboro�s dividend-payout ratios. Plainly, the 40 percent dividend-payout ratio violates Eastboro�s maximum debt/equity ratio of 40 percent.

The conclusion is that, because dividend policy affects creditworthiness, senior managers should weigh the financial side effects of their payout decisions, along with the signaling, segmentation, and investment effects, in arriving at a final choice of dividend policy.

Debt/Equity Ratios by Dividend Payout

-10.0%0.0%

10.0%20.0%30.0%40.0%50.0%60.0%

2001

2002

2003

2004

2005

2006

2007

Year

Deb

t/Equ

ity R

atio

0% Payout

10% Payout

20% Payout

30% Payout

40% Payout

MaximumDebt/Equity

Exhibit TN2 EASTBORO MACHINE TOOLS CORPORATION Supplemental Note: Setting Debt and Dividend-Payout Targets

The Eastboro Machine Tools Corporation case illustrates well the challenge of setting the two most obvious components of financial policy: target payout and debt capitalization. The policies are linked with the growth target of the firm, as shown in the self-sustainable growth model: gss = (P/S *S/A*A/E)(1-DPO)

Where:

gss is the self-sustainable growth rate P is net income S is sales A is assets E is equity DPO is dividend-payout ratio

This model describes the rate at which a firm can grow provided that it issues no new shares of common stock, which describes the behavior or circumstances of virtually all firms. The model illustrates that the financial policies of a firm are a closed system: growth rate, dividend payout, and debt targets are interdependent. The model offers the key insight that no financial policy can be set without reference to the others. As Eastboro shows, a high dividend payout affects the firm�s ability to achieve growth and capitalization targets and vice versa. Myopic policy�failing to manage the link among the financial targets�will result in the failure to meet financial targets. Setting Debt-Capitalization Targets

Finance theory is split on whether gains are created by optimizing the mix of debt and equity of the firm. Practitioners and many academicians, however, believe that debt optima exist and devote great effort to choosing the firm�s debt-capitalization targets. Several classic competing considerations influence the choice of debt targets:


1. Exploit debt-tax shields. Modigliani and Miller�s theory implies that in a world of taxes, debt financing creates value.1 Later, Miller theorized that when personal taxes are accounted for, the leverage choices of the firm might not create value. So far, the bulk of the empirical evidence suggests that leverage choices do affect value.

2. Reduce costs of financial distress and bankruptcy. Modigliani and Miller�s theory naively

implied that firms should lever up to 99 percent of capital. Virtually no firms do this. Beyond some prudent level of debt, the cost of capital becomes very high because investors recognize that the firm has a greater probability of suffering financial distress and bankruptcy. The critical question then becomes: What is �prudent�? In practice, two classic benchmarks are used:

Industry-average debt/capital. Many firms lever to the degree practiced by peers, but this policy is not very sensible. Industry averages ignore differences in accounting policies, strategies, and earnings outlooks. Ideally, prudence is defined in firm-specific terms. In addition, capitalization ratios ignore the crucial fact that a firm goes bankrupt because it runs out of cash, not because it has a high debt/capital ratio.

Firm-specific debt service. More firms are setting debt targets on the basis of forecasted ability to cover principal and interest payments with earnings before interest and taxes (EBIT). This practice requires forecasting the annual probability distribution of EBIT and setting the debt-capitalization level so that the probability of covering debt service is consistent with management�s strategy and risk tolerance.

3. Maintain a reserve against unforeseen adversities or opportunities. Many firms keep their

cash balances and lines of unused bank credit larger than may seem necessary, because managers want to be able to respond to sudden demands on the firm�s financial resources caused, for example, by a price war, a large product recall, or an opportunity to buy the toughest competitor. Academicians have no scientific advice about how large these reserves should be.

4. Maintain future access to capital. In difficult economic times, less creditworthy borrowers

may be shut out from the capital markets and unable to obtain funds. In the United States, �less creditworthy� means companies whose debt ratings are less than investment grade (i.e., less than BBB2 or Baa3). Accordingly, many firms set debt targets in such a way as to at least maintain a creditworthy (i.e., investment-grade) debt rating.

1Actually, value is transferred from the public sector (loss of tax revenue) to the private sector. From a

macroeconomic standpoint, no value has been created. 2BBB is the lowest investment-grade bond rating awarded by Standard & Poor�s, a bond-rating agency.


5. Opportunism: exploiting capital-market windows. Some firms� debt policies vary across the capital-market cycle. These firms issue debt when interest rates are low (and issue stock when stock prices are high); they are bargain-hunters (even though no bargains exist in an efficient market). Opportunism does not explain how firms set targets so much as why firms deviate from the targets.

Setting Dividend-Payout Targets

In theory, dividend policy should have no effect on the value of a firm�s shares. Nonetheless, dividend-payout decisions absorb so much of the time of highly paid, bright, senior executives that dividend payout must be important economically. These are the key considerations that emerge in payout decisions:

1. Financing attractive investments. Miller and Modigliani�s famous dividend irrelevance theory suggests that dividend policy should be set as a residual-that is, the real question to ask is whether and how the firm can finance all of its positive net-present-value investment opportunities. Under this view, dividends paid out are simply the cash flow that remains after a firm makes attractive investments.

2. Sending signals. Executives do not want to tell the world what they foresee for their

companies, because that projection would telegraph their moves to their competitors. Paying progressively higher dividends is one way to convey optimism about the future. The investment community, however, forms its own expectations about the firm�s future and dividend payments. Dividends have signaling content when they deviate from investors’ expectations: a surprisingly high or low change in dividend payments conveys news to investors. Cutting a dividend (even to finance an attractive investment) is universally perceived as bad news.

3. Building a reputation. Academic research finds that dividend payments �ratchet� up: they

tend to rise or hold steady, but rarely fall. Many companies advertise their unbroken string of annual dividend increases. Managers believe that dividend payout builds a reputation of investment performance.

3Baa is the lowest investment-grade bond rating awarded by Moody�s Investment Service, a bond-rating agency.


4. Segmenting the capital market and attracting an investor clientele. If capital markets are not homogeneous, some investors will pay more for the share of high-payout firms and others will pay less. From this point of view, chief financial officers should be like consumer marketers, aiming to position their �product� (e.g., their shares) to the investor clientele that is willing to pay the most. The firm�s choice of dividend payout may influence the position of its shares. This view is provocative and not easily implemented for large public corporations. On the other hand, this consideration is enormously important for privately owned businesses, because it suggests that managers should listen to the owners� needs for cash.

Conclusion

Corporate debt-and-dividend policies emerge after weighing difficult trade-offs among competing desirable ends. No algorithm or model straightforwardly dictates policies. As analysts and managers, we confront the need to run the decision process well by ensuring that all trade-offs surface and all arguments are heard. Ultimately, good policies will meet these three tests:

1. Do they create value? 2. Do they create competitive advantage? 3. Do they sustain the managerial vision?

Exhibit TN3 EASTBORO MACHINE TOOLS CORPORATION Impact of Dividend Payout on Need for External Funds by 2007 (dollars in millions)

0% 20% 40% 50%Net Profit 537.8$ 537.8$ 537.8$ 537.8$ Less dividends - 107.6 215.1 268.9 Earnings retained 537.8 430.2 322.7 268.9 New debt (stock buy-back) (119.3) (11.9) 95.5 149.2Depreciation 252.0 252.0 252.0 252.0 Increase in assets 670.5 670.3 670.2 670.1

Initial debt (2000) 80.3 80.3 80.3 80.3

Change in debt - - 95.5 149.2

Ending debt (2007) 80.3 80.3 175.8 229.5

Initial equity (2000) 282.5 282.5 282.5 282.5 Earnings retained 537.8 430.2 322.7 268.9

Stock buyback (119.3) (11.9) - -

Ending equity (2007) 701.0 700.9 605.2 551.4 Total capital 781.3 781.1 781.0 780.9

Debt/total capital 10.3% 10.3% 22.5% 29.4%Debt/equity 11.5% 11.5% 29.0% 41.6%

Debt capacity 280.4 280.3 242.1 220.6 (@.4=max debt/equity)Debt capacity used 80.3 80.3 175.8 229.5 Unused debt capacity 200.1 200.1 66.3 (8.9)

1.40 1.40

Targeted Dividend Payout

Ratio of debt capacity used to incremental payments to shareholders

Exhibit TN4 EASTBORO MACHINE TOOLS CORPORATION Sensitivity Analysis of Debt/Equity Results to Variations in Payout Ratio

N.B.: Negative debt/equity ratios imply that the firm has repaid debt and carries excess cash.

Dividend Payout 2001 2002 2003 2004 2005 2006 20070% 34.7% 33.4% 27.9% 21.3% 12.4% 6.0% -5.4%

10% 35.6% 35.9% 32.1% 27.0% 19.1% 13.5% 2.3%20% 36.5% 38.5% 36.6% 33.2% 26.7% 22.1% 11.4%30% 37.4% 41.2% 41.5% 40.1% 35.2% 32.0% 22.2%40% 38.3% 44.0% 46.6% 47.7% 45.1% 43.8% 35.4%

Max. D/E Ratio 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%

Debt/Equity Ratios by Dividend Payout

-10.0%0.0%

10.0%20.0%30.0%40.0%50.0%60.0%

2001

2002

2003

2004

2005

2006

2007

Year

Deb

t/Equ

ity R

atio

0% Payout

10% Payout

20% Payout

30% Payout

40% Payout

MaximumDebt/Equity

Exhibit TN5 EASTBORO MACHINE TOOLS CORPORATION Forecast of Financing Need Assuming 40 Percent Payout1 (dollars in millions)

1The model adds any excess cash flow (which results in negative debt) to the base to calculate unused debt capacity, at a maximum debt/equity ratio of 40%. 2Weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Eastboro�s targeted business mix, a weight of 75% is assigned to the average P/E of the CAD/CAM companies, and 25% to the average P/E of the electrical-industrial-equipment and machine-tool manufacturers. 3EPS times assumed P/E.

Common Assumptions1 Sales Growth 15.0%2 Net Income Margin 2.1% 4.0% 5.0% 5.5% 6.0% 5.6% 8.0%3 Dividend Payout 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%4 Beginning Debt 80.1 5 Beginning Equity 282.5 6 Shares Outstanding 18.3 7 Price Earnings Ratio (2) 33.0 8 Current Market Price $22.159 Debt/Equity Maximum 40.0%

10 Borrowing Rate 8.0%11 Tax Rate 34.0%

Total2001 2002 2003 2004 2005 2006 2007 2002-07

13 Sales $870.0 $1,000.5 $1,150.6 $1,323.2 $1,521.6 $1,749.9 $2,012.4

Sources:14 Net Income 18.1 40.0 57.5 72.8 91.3 98.0 160.0 537.715 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.016 Total Sources 40.6 65.5 87.5 107.3 131.8 144.5 212.5 789.7

Uses:17 Capital Expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.618 Working Capital 19.5 22.4 25.8 29.6 34.0 38.5 44.319 Total Uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

20 Excess Cash (Borrowings) (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6 119.921 Dividends 7.2 16.0 23.0 29.1 36.5 39.2 64.0 (215.1)22 Net (29.9) (23.3) (18.8) (17.6) (7.2) (12.0) 13.6 (95.1)23 Cumulative Source (Need) (29.9) (53.2) (72.0) (89.6) (96.8) (108.8) (95.1)24 Int. Cost-New Debt (1.6) (2.8) (3.8) (4.7) (5.1) (5.7) (5.0) (28.8)25 Net Source (Need) (31.5) (56.0) (75.8) (94.4) (101.9) (114.5) (100.2)26 Debt (Excess) 111.6 137.7 160.3 182.6 194.9 212.6 204.0 177.427 Equity 291.8 313.0 343.7 382.7 432.3 485.4 576.4 511.028 Debt/Equity 38.3% 44.0% 46.6% 47.7% 45.1% 43.8% 35.4% 34.7%29 Unused Debt Capacity 5.1 (12.5) (22.8) (29.6) (22.0) (18.5) 26.5 27.0

30 Return on Avg. Equity 5.8% 12.3% 16.4% 18.7% 21.2% 20.1% 29.2%31 EPS $0.90 $2.03 $2.93 $3.71 $4.70 $5.03 $8.4532 Implied Stock Price (3) $29.71 $66.95 $96.66 $122.42 $155.06 $165.97 $278.7933 Dividends Per Share $0.39 $0.87 $1.25 $1.59 $1.99 $2.14 $3.49

Return to Investor:34 Stock Value (Terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $278.7935 Dividend Received $0.39 $0.87 $1.25 $1.59 $1.99 $2.14 $3.4936 Total Cap. Apprec. & Divs. ($22.15) $0.39 $0.87 $1.25 $1.59 $1.99 $2.14 $282.2837 NPV (@ 12%) $98.8438 Return (IRR) 45.8%

Exhibit TN6 EASTBORO MACHINE TOOLS CORPORATION Forecast of Financing Need Assuming 20 Percent Payout1 (dollars in millions)




Total2001 2002 2003 2004 2005 2006 2007 2002-07

13 Sales $870.0 $1,000.5 $1,150.6 $1,323.2 $1,521.6 $1,749.9 $2,012.4



20 Excess Cash (Borrowings) (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6 119.921 Dividends 3.6 8.0 11.5 14.6 18.3 19.6 32.0 (107.5)22 Net (26.3) (15.3) (7.3) (3.0) 11.1 7.6 45.6 12.423 Cumulative Source (Need) (26.3) (41.6) (48.9) (51.9) (40.8) (33.2) 12.424 Int. Cost-New Debt (1.4) (2.2) (2.6) (2.7) (2.2) (1.8) 0.7 (12.2)25 Net Source (Need) (27.7) (43.8) (51.5) (54.7) (43.0) (35.0) 13.126 Debt (Excess) 107.8 125.3 135.2 140.9 132.0 126.1 79.9 53.327 Equity 295.6 325.4 368.9 424.4 495.2 571.9 700.5 618.628 Debt/Equity 36.5% 38.5% 36.6% 33.2% 26.7% 22.1% 11.4% 8.6%29 Unused Debt Capacity 10.4 4.9 12.4 28.8 66.1 102.6 200.3 194.2



Exhibit TN7 EASTBORO MACHINE TOOLS CORPORATION Forecast of Financing Need Assuming Residual Dividend Policy, Lower Growth, and Lower Margins1 (dollars in millions)




Total2001 2002 2003 2004 2005 2006 2007 2002-07

13 Sales $870.0 $974.4 $1,091.3 $1,222.3 $1,369.0 $1,533.2 $1,717.2



20 Excess Cash (Borrowings) (31.4) (18.1) (9.7) (6.3) 6.5 (0.2) 37.0 -22.121 Dividends 2.0 0.0 0.0 2.6 19.8 15.0 54.1 (93.6)22 Net (33.4) (18.1) (9.7) (8.9) (13.3) (15.3) (17.2) (115.7)23 Cumulative Source (Need) (33.4) (51.5) (61.1) (70.0) (83.3) (98.5) (115.7)24 Int. Cost-New Debt (1.8) (2.7) (3.2) (3.7) (4.4) (5.2) (6.1) (27.1)25 Net Source (Need) (35.2) (54.2) (64.4) (73.7) (87.7) (103.8) (121.8)26 Debt (Excess) 115.3 136.0 149.0 161.5 179.2 199.7 222.9 196.327 Equity 288.2 314.7 355.1 403.8 448.1 498.4 557.5 490.428 Debt/Equity 40.0% 43.2% 41.9% 40.0% 40.0% 40.1% 40.0% 40.0%29 Unused Debt Capacity (0.0) (10.2) (6.9) (0.0) 0.0 (0.3) 0.1 (0.1)



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