Gainsboro

Gainesboro Seminar 5

To raise dividends a company can invest less, borrow more or issue more shares. Which of these elements of strategy is Gainesboro most likely to change?

Gainesboro has an ambitious strategy for the company to achieve a growth rate of 15% per annum. This involves expanding aggressively internationally and acquiring small software companies to provide half of its new products. This strategy rules out raising dividends by investing less in the company. Therefore, Gainesboro may either borrow more or issue more shares. The problem with issuing more shares is that it dilutes the value for the existing shareholders, and hence this won’t be a popular move for shareholders. Therefore I think that Gainesboro is most likely to borrow to issue dividends. Management has an aversion to debt, and believe that a debt to equity ratio should not be more than 40%. Projections for 2005 has the debt to equity ratio at 35%, with the company taking on more debt than it had in the past. Compared to 2003 where the debt to equity ratio was 11%. This is certainly the best option for Gainesboro, however the company just needs to careful that this additional borrowing to pay for dividends puts undue pressure on the firm, who is already borrowing to finance its business activities which has been assumed to generate a positive and aggressive 15% growth.

What happens to Gainesboro’s financing needs and unused debt capacity in the case that it pays no dividends, 20%, 40% or a residual dividend?

Pays no dividends – If it pays no dividends, then Gainesboro would be able to channel all its earnings to fund its growth strategy. Its unused debt capacity would be channelled towards the high cash requirements of the firm’s strategic emphasis on advanced technologies and CAD/CAM.

20% - With a 20% payout ratio, the firm would have positive excess cash from 2009 instead positive excess cash from 2011 with a 40% payout ratio. This will enable the firm to use its excess debt...