Gainesboro Machine Tools

1.

Gainesboro has been debt averse since its inception. Management tries to maintain 40% debt to equity ratio and its highest debt to capital ratio was 22% in 2004. Of the three elements – invest less, borrow more, or issue more stock, Gainesboro is not willing to borrow more as a matter of the company’s policy. Gainesboro’s management is also looking to invest and expand so they would not want to invest less. Gainesboro management would consider issuing more stocks to maintain its low debt to equity levels because they are more interested in capital financing than debt financing.

2. A. If no dividends are paid there is excess cash for years 2007 – 2011 which means borrowing needs are minimal for those years.

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B. If a 20% payout is pursued, there is negative excess cash for the first four years and borrowing needs decrease from 2009 – 2011.

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C. If a 40% payout is pursued there is negative excess cash for all of the years except for 2011 which increases borrowing needs.

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D. If a residual payout policy is pursued, as net income increases, capital budget and the dividend payout ratio increases.

Year 2005: CB = 43.8

40% Debt to equity ratio

Net Income = 18.1

.4 (43.8) = 17.52 funded with equity

18.1 – 17.52 = .58 left over to pay as dividends

.58/18.1 = .03 = 3% dividend payout ratio

Year 2006: CB = 50.4

40% Debt equity ratio

Net Income = 40.0

.4(50.4) = 20.16 funded with equity

40.0 – 20.16 = 19.8 left over to pay as dividends

19.8/40 = .49 = 49% dividend payout ratio

Year 2007: CB = 57.5

40% debt equity ratio

Net Income = 57.5

.4(57.5) = 23 funded with equity

57.5-23 = 34.5 left over to pay as dividends...