Eastboro Case Solution

Case 24
Version 1.1
Eastboro Machine Tools Corporation

Teaching Note
Synopsis and Objectives

In mid-September 2001, Jennifer Campbell, the chief financial
Other cases in which
officer of this large CAD/CAM (computer-aided design and dividend policy is an
manufacturing) equipment manufacturer must decide whether to pay out important issue:
dividends to the firms shareholders, or repurchase stock. If Campbell Deutsche Brauerei
chooses to pay out dividends, she must also decide on the magnitude of the (case 10).
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.
Merton Miller and Franco Modigliani, Dividend Policy, Growth, and the Valuation of Shares, Journal of Business
34 (October 1961): 411-33.
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 dardencases@virginia.edu. 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 meanselectronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.
333
334
Case 24 Eastboro Machine Tools Corporation
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 Eastboros financing need and unused debt capacity if
a.
b.
c.
d.
no dividends are paid?

a 20 percent payout is pursued?
a 40 percent payout is pursued?
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 Eastboros 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
2
Paul Asquith and David W. Mullins, Jr., Signaling with Dividends, Stock Repurchases, and Equity Issues,
Financial Management (Autumn 1986): 27-44.
3
See How to Communicate with an Efficient Market and A Discussion of Corporate Financial Communication in
Midland Corporate Finance Journal 2 (Spring 1984).
335
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
firms shares in the equity market.
2. What are the implications of different payout levels for Eastboros 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
Eastboros 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 firms 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.
336
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 firms 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
Eastboros asset needs
The companys investment spending and financing requirements are driven
Discussion
by ambitious growth goals (a 15 percent annual target is discussed in the case),
Question 2
which are to be achieved by a repositioning of the firmaway from its traditional
tools-and-molds business and beyond its CAD/CAM business into a new line of
products integrating hardware and softwareto provide complete manufacturing systems.
CAD/CAM commanded 45 percent of total sales ($340.5 million) in 2000 and is to grow to threequarters 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-andmolds segment will grow at about 2.7 percent annually in nominal terms, which implies a negative
Fisher 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.
5
International 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).
337
real rate of growth in what constitutes the bulk of Eastboros current business.6 In short, the
companys 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:
Discussion
Question 3
Asset change = New debt + (Profits - Dividends)

With asset additions fixed largely by the firms competitive strategy, and with profits
determined largely by the firms 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 firms 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 firms 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 firms financing and unused debt capacity. The principal insight
this analysis yields is that the firms 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 capacityevery
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
Presses 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.
7
The 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.
8
Unused debt capacity of $134 additional dividends paid of $95 results in a ratio of about 1.4.
338
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 payoutsthis 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
Discussion
from the plan. Case Exhibit 8 assumes no cyclical downturn over the seven-year
Question 4
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 firms 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 companys 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 managements ability to begin
harvesting potential profits. Plainly, the Artificial Workforce has the competitive advantage at the
moment, but the volatility of the firms 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
9
A discount rate of 12 percent is used for illustrative purposes. Presumably, the required return on equity would vary
with the leverage of the firm.
10
These 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.
339
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 firms
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
Discussion
intrinsic value of Eastboro is greater than its current share price, the shares should be
Question 5
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 Eastboros 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 Eastboros 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 Eastboros 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),
11
Discussion
Question 6
This violates the rule that free cash flows should reflect prefinancing cash flows. However, we are not given
any operating income assumptions.
340
seeks to maximize growth in the market value of the companys 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 firms 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 boards 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
dividendalmost any dividendmight 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
12
These 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).
13
From The Memoirs of Sherlock Holmes by Sir Arthur Conan Doyle.
14
Paul Asquith and David W. Mullins, Jr., Signaling with Dividends, Stock Repurchases, and Equity Issues,
Financial Management (Autumn 1986): 27-44.
341
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 firms investment strategy; Miller and Modiglianis16 dividend-irrelevance theorem
makes the point that the firms investmentsnot the dividends it paysdetermine 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 highpayout 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
Discussion
Question 1 and
declare a dividend in the third quarter (although, for practical purposes, students
Closing Vote
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 firmEastboros 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.
15
Irwin Friend and M. Puckett, Dividends and Stock Prices, American Economic Review 54 (September 1964):
656-82.
16
Merton Miller and Franco Modigliani, Dividend Policy, Growth, and the Valuation of Shares, Journal of
Business 34 (October 1961): 411-33.
342
The arguments in favor of a low payout are usually based on optimism about the firms
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 firms 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 boards 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 Blacks term, largely because of its interaction
with other corporate policies and its signaling effect.17 Decisions about the firms 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.
17
Fisher Black, The Dividend Puzzle, Journal of Portfolio Management (Winter 1976): 5-8.
343
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 firms 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.
Net Profit
Less dividends
Earnings retained
New debt (stock buy-back)
Depreciation
Increase in assets
Initial debt (2000)
Change in debt
Targeted Dividend Payout

0%
20%
40%
$
537.8 $
537.8 $
537.8 $
107.6
215.1
537.8
430.2
322.7
(119.3)
(11.9)
95.5
252.0
252.0
252.0
670.5
670.3
670.2
80.3
80.3
80.3
Remarks
50%
537.8
268.9
268.9
149.2
252.0
670.1
80.3
Zero if (retained earnings + depreciation) >=
increase in assets; otherwise the difference
149.2
between (retained earnings + depreciation) and
(increase in assets)
95.5
Ending debt (2007)
80.3
80.3
175.8
229.5
Initial equity (2000)

Earnings retained
282.5
537.8
282.5
430.2
282.5
322.7
282.5
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
Debt/equity
10.3%
11.5%
10.3%
11.5%
22.5%
29.0%
29.4%
41.6%
Debt capacity
(@.4=max debt/equity)
Debt capacity used
Unused debt capacity
Ratio of debt capacity used to
incremental payments to shareholders
280.4
280.3
242.1
220.6
80.3
200.1
80.3
200.1
175.8
66.3
229.5
(8.9)
Zero if (retained earnings + depreciation) <=

increase in assets; otherwise the difference
between (retained earnings + depreciation) and
(increase in assets)
Incremental debt / incremental dividends and
1.40
1.40 stock buybacks
344
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 surprisingunder 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
Eastboros dividend-payout ratios.
Debt/Equity Ratio
Debt/Equity Ratios by Dividend Payout

60.0%
0% Payout
50.0%
40.0%
30.0%
10% Payout
20.0%
20% Payout
10.0%
0.0%
30% Payout
-10.0%
Year
07
20
06
20
05
20
04
20
03
20
02
20
20
01
40% Payout
Maximum
Debt/Equity
Plainly, the 40 percent dividend-payout ratio violates Eastboros 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.
345
Exhibit TN2
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 firms ability
to achieve growth and capitalization targets and vice versa. Myopic policyfailing to manage the
link among the financial targetswill 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 firms debt-capitalization targets. Several classic competing
considerations influence the choice of debt targets:
346

1. Exploit debt-tax shields. Modigliani and Millers 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 Millers 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 managements 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 firms 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.
1
Actually, value is transferred from the public sector (loss of tax revenue) to the private sector. From a
macroeconomic standpoint, no value has been created.
2
BBB is the lowest investment-grade bond rating awarded by Standard & Poors, a bond-rating agency.
347

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 firms 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 Modiglianis 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 firms 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.
Baa is the lowest investment-grade bond rating awarded by Moodys Investment Service, a bond-rating agency.
348

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 firms 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
Impact of Dividend Payout on Need for External Funds by 2007
(dollars in millions)
Net Profit
Less dividends
Earnings retained
New debt (stock buy-back)
Depreciation
Increase in assets
Initial debt (2000)
0%
537.8
537.8
(119.3)
252.0
670.5
Targeted Dividend Payout

20%
40%
$
537.8 $
537.8 $
107.6
215.1
430.2
322.7
(11.9)
95.5
252.0
252.0
670.3
670.2
50%
537.8
268.9
268.9
149.2
252.0
670.1
80.3
80.3
80.3
80.3
95.5
149.2
Ending debt (2007)
80.3
80.3
175.8
229.5
Initial equity (2000)

Earnings retained
282.5
537.8
282.5
430.2
282.5
322.7
282.5
268.9
(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
Debt/equity
10.3%
11.5%
10.3%
11.5%
22.5%
29.0%
29.4%
41.6%
Debt capacity
(@.4=max debt/equity)
Debt capacity used
Unused debt capacity
Ratio of debt capacity used to
incremental payments to shareholders
280.4
280.3
242.1
220.6
80.3
200.1
80.3
200.1
175.8
66.3
229.5
(8.9)
1.40
1.40
Change in debt
Stock buyback
349
350
Exhibit TN4
Sensitivity Analysis of Debt/Equity Results to Variations in Payout Ratio
Dividend Payout
0%
10%
20%
30%
40%
Max. D/E Ratio
2001
34.7%
35.6%
36.5%
37.4%
38.3%
40.0%
2002
33.4%
35.9%
38.5%
41.2%
44.0%
40.0%
2003
27.9%
32.1%
36.6%
41.5%
46.6%
40.0%
2004
21.3%
27.0%
33.2%
40.1%
47.7%
40.0%
2005
12.4%
19.1%
26.7%
35.2%
45.1%
40.0%
2006
6.0%
13.5%
22.1%
32.0%
43.8%
40.0%
0% Payout
60.0%
50.0%
40.0%
30.0%
10% Payout
20% Payout
20.0%
10.0%
0.0%
-10.0%
30% Payout
40% Payout
20
01
20
02
20
03
20
04
20
05
20
06
20
07
Debt/Equity Ratio
Debt/Equity Ratios by Dividend Payout
Year
Maximum
Debt/Equity
N.B.: Negative debt/equity ratios imply that the firm has repaid debt and carries excess cash.
2007
-5.4%
2.3%
11.4%
22.2%
35.4%
40.0%
351
Exhibit TN5
Forecast of Financing Need Assuming 40 Percent Payout1
1
2
3
4
5
6
7
8
9
10
11
Common Assumptions
Sales Growth
Net Income Margin
Dividend Payout
Beginning Debt
Beginning Equity
Shares Outstanding
Price Earnings Ratio (2)
Current Market Price
Debt/Equity Maximum
Borrowing Rate
Tax Rate
15.0%
2.1%
40.0%
80.1
282.5
18.3
4.0%
40.0%
5.0%
40.0%
5.5%
40.0%
6.0%
40.0%
5.6%
40.0%
8.0%
40.0%
2002
$1,000.5
2003
$1,150.6
2004
$1,323.2
2005
$1,521.6
2006
$1,749.9
2007
$2,012.4
33.0
$22.15
40.0%
8.0%
34.0%
2001
$870.0
13 Sales
Total
2002-07
Sources:
14 Net Income
15 Depreciation
16 Total Sources
18.1
22.5
40.6
40.0
25.5
65.5
57.5
30.0
87.5
72.8
34.5
107.3
91.3
40.5
131.8
98.0
46.5
144.5
160.0
52.5
212.5
537.7
252.0
789.7
Uses:
17 Capital Expenditures
18 Working Capital
19 Total Uses
43.8
19.5
63.3
50.4
22.4
72.8
57.5
25.8
83.3
66.2
29.6
95.8
68.5
34.0
102.4
78.8
38.5
117.3
90.6
44.3
134.9
669.8
(22.7)
7.2
(29.9)
(29.9)
(1.6)
(31.5)
111.6
291.8
38.3%
5.1
(7.3)
16.0
(23.3)
(53.2)
(2.8)
(56.0)
137.7
313.0
44.0%
(12.5)
4.2
23.0
(18.8)
(72.0)
(3.8)
(75.8)
160.3
343.7
46.6%
(22.8)
11.5
29.1
(17.6)
(89.6)
(4.7)
(94.4)
182.6
382.7
47.7%
(29.6)
29.4
36.5
(7.2)
(96.8)
(5.1)
(101.9)
194.9
432.3
45.1%
(22.0)
27.2
39.2
(12.0)
(108.8)
(5.7)
(114.5)
212.6
485.4
43.8%
(18.5)
77.6
64.0
13.6
(95.1)
(5.0)
(100.2)
204.0
576.4
35.4%
26.5
5.8%
$0.90
12.3%
$2.03
16.4%
$2.93
18.7%
$3.71
21.2%
$4.70
20.1%
$5.03
29.2%
$8.45
20
21
22
23
24
25
26
27
28
29
Excess Cash (Borrowings)

Dividends
Net
Cumulative Source (Need)
Int. Cost-New Debt
Net Source (Need)
Debt (Excess)
Equity
Debt/Equity
Unused Debt Capacity
30 Return on Avg. Equity

31 EPS
(3)
32 Implied Stock Price
33 Dividends Per Share
34
35
36
37
38
1
Return to Investor:
Stock Value (Terminal)
Dividend Received
Total Cap. Apprec. & Divs.
NPV (@ 12%)
Return (IRR)
($22.15)
$29.71
$0.39
$66.95
$0.87
$96.66
$1.25
$122.42
$1.59
$155.06
$1.99
$165.97
$2.14
$278.79
$3.49
$0.00
$0.39
$0.39
$98.84
45.8%
$0.00
$0.87
$0.87
$0.00
$1.25
$1.25
$0.00
$1.59
$1.59
$0.00
$1.99
$1.99
$0.00
$2.14
$2.14
$278.79
$3.49
$282.28
119.9
(215.1)
(95.1)
(28.8)
177.4
511.0
34.7%
27.0
The 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%.
Weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Eastboros 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.
3
EPS times assumed P/E.
2
352
Exhibit TN6
Forecast of Financing Need Assuming 20 Percent Payout1
1
2
3
4
5
6
7
8
9
10
11
Common Assumptions
Sales Growth
Net Income Margin
Dividend Payout
Beginning Debt
Beginning Equity
Shares Outstanding
Debt/Equity Maximum
Borrowing Rate
Tax Rate
15.0%
2.1%
20.0%
80.1
282.5
18.3
5.0%
20.0%
5.5%
20.0%
6.0%
20.0%
5.6%
20.0%
8.0%
20.0%
2002
$1,000.5
2003
$1,150.6
2004
$1,323.2
2005
$1,521.6
2006
$1,749.9
2007
$2,012.4
33.0
$22.15
40.0%
8.0%
34.0%
2001
$870.0
13 Sales
Total
2002-07
Sources:
14 Net Income
15 Depreciation
16 Total Sources
18.1
22.5
40.6
40.0
25.5
65.5
57.5
30.0
87.5
72.8
34.5
107.3
91.3
40.5
131.8
98.0
46.5
144.5
160.0
52.5
212.5
537.7
252.0
789.7
Uses:
18 Working Capital
19 Total Uses
43.8
19.5
63.3
50.4
22.4
72.8
57.5
25.8
83.3
66.2
29.6
95.8
68.5
34.0
102.4
78.8
38.5
117.3
90.6
44.3
134.9
669.8
(22.7)
3.6
(26.3)
(26.3)
(1.4)
(27.7)
107.8
295.6
36.5%
10.4
(7.3)
8.0
(15.3)
(41.6)
(2.2)
(43.8)
125.3
325.4
38.5%
4.9
4.2
11.5
(7.3)
(48.9)
(2.6)
(51.5)
135.2
368.9
36.6%
12.4
11.5
14.6
(3.0)
(51.9)
(2.7)
(54.7)
140.9
424.4
33.2%
28.8
29.4
18.3
11.1
(40.8)
(2.2)
(43.0)
132.0
495.2
26.7%
66.1
27.2
19.6
7.6
(33.2)
(1.8)
(35.0)
126.1
571.9
22.1%
102.6
77.6
32.0
45.6
12.4
0.7
13.1
79.9
700.5
11.4%
200.3
5.8%
$0.91
12.2%
$2.06
15.8%
$3.00
17.7%
$3.82
19.4%
$4.86
18.0%
$5.25
25.2%
$8.76
20
21
22
23
24
25
26
27
28
29

Dividends
Net
Int. Cost-New Debt
Net Source (Need)
Debt (Excess)
Equity
Debt/Equity

31 EPS
(3)
34
35
36
37
38
1
4.0%
20.0%
Return to Investor:
Dividend Received
NPV (@ 12%)
Return (IRR)
($22.15)
$30.06
$0.20
$68.05
$0.44
$98.86
$0.63
$126.00
$0.79
$160.38
$1.00
$173.15
$1.07
$289.01
$1.74
$0.00
$0.20
$0.20
$99.96
45.4%
$0.00
$0.44
$0.44
$0.00
$0.63
$0.63
$0.00
$0.79
$0.79
$0.00
$1.00
$1.00
$0.00
$1.07
$1.07
$289.01
$1.74
$290.75
119.9
(107.5)
12.4
(12.2)
53.3
618.6
8.6%
194.2
3
2
353
Exhibit TN7
Forecast of Financing Need Assuming Residual Dividend Policy,
Lower Growth, and Lower Margins1
1
2
3
4
5
6
7
8
9
10
11
Common Assumptions
Sales Growth
Net Income Margin
Dividend Payout
Beginning Debt
Beginning Equity
Shares Outstanding
Debt/Equity Maximum
Borrowing Rate
Tax Rate
12.0%
1.1%
21.3%
80.1
282.5
18.3
3.0%
0.0%
4.0%
0.0%
4.5%
4.8%
5.0%
28.9%
4.6%
21.3%
7.0%
45.4%
2002
$974.4
2003
$1,091.3
2004
$1,222.3
2005
$1,369.0
2006
$1,533.2
2007
$1,717.2
33.0
$22.15
40.0%
8.0%
34.0%
2001
$870.0
13 Sales
Total
2002-07
Sources:
14 Net Income
15 Depreciation
16 Total Sources
9.4
22.5
31.9
29.2
25.5
54.7
43.7
30.0
73.7
55.0
34.5
89.5
68.4
40.5
108.9
70.5
46.5
117.0
119.3
52.5
171.8
395.6
252.0
647.6
Uses:
18 Working Capital
19 Total Uses
43.8
19.5
63.3
50.4
22.4
72.8
57.5
25.8
83.3
66.2
29.6
95.8
68.5
34.0
102.4
78.8
38.5
117.3
90.6
44.3
134.9
669.8
(31.4)
2.0
(33.4)
(33.4)
(1.8)
(35.2)
115.3
288.2
40.0%
(0.0)
(18.1)
0.0
(18.1)
(51.5)
(2.7)
(54.2)
136.0
314.7
43.2%
(10.2)
(9.7)
0.0
(9.7)
(61.1)
(3.2)
(64.4)
149.0
355.1
41.9%
(6.9)
(6.3)
2.6
(8.9)
(70.0)
(3.7)
(73.7)
161.5
403.8
40.0%
(0.0)
6.5
19.8
(13.3)
(83.3)
(4.4)
(87.7)
179.2
448.1
40.0%
0.0
(0.2)
15.0
(15.3)
(98.5)
(5.2)
(103.8)
199.7
498.4
40.1%
(0.3)
37.0
54.1
(17.2)
(115.7)
(6.1)
(121.8)
222.9
557.5
40.0%
0.1
2.7%
$0.42
8.8%
$1.45
12.1%
$2.20
13.5%
$2.80
15.0%
$3.49
13.8%
$3.56
21.4%
$6.17
20
21
22
23
24
25
26
27
28
29

Dividends
Net
Int. Cost-New Debt
Net Source (Need)
Debt (Excess)
Equity
Debt/Equity

31 EPS
(3)
34
35
36
37
38
1
Return to Investor:
Dividend Received
NPV (@ 12%)
Return (IRR)
($22.15)
$13.73
$0.11
$47.70
$0.00
$72.73
$0.00
$92.31
$0.14
$115.24
$1.08
$117.53
$0.82
$203.73
$2.95
$0.00
$0.11
$0.11
$64.78
38.0%
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.14
$0.14
$0.00
$1.08
$1.08
$0.00
$0.82
$0.82
$203.73
$2.95
$206.68
-22.1
(93.6)
(115.7)
(27.1)
196.3
490.4
40.0%
(0.1)
3
2

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Case 24

Eastboro Machine Tools Corporation

Synopsis and Objectives

Case 24 Eastboro Machine Tools Corporation

Suggested Questions for Advance Assignment to Students

no dividends are paid?

Supporting Computer Spreadsheet Diskfiles

Case 24 Eastboro Machine Tools Corporation

Hypothetical Teaching Plan

Case 24 Eastboro Machine Tools Corporation

Case 24 Eastboro Machine Tools Corporation

Asset change = New debt + (Profits - Dividends)

Case 24 Eastboro Machine Tools Corporation

Case 24 Eastboro Machine Tools Corporation

Case 24 Eastboro Machine Tools Corporation

Case 24 Eastboro Machine Tools Corporation

Case 24 Eastboro Machine Tools Corporation

Case 24 Eastboro Machine Tools Corporation

Targeted Dividend Payout

Ending debt (2007)

Initial equity (2000)

Ending equity (2007)

Zero if (retained earnings + depreciation) <=

Incremental debt / incremental dividends and

1.40 stock buybacks

Case 24 Eastboro Machine Tools Corporation

Exhibit TN1 (continued)

Debt/Equity Ratios by Dividend Payout

Case 24 Eastboro Machine Tools Corporation

Setting Debt-Capitalization Targets

Case 24 Eastboro Machine Tools Corporation

Exhibit TN2 (continued)

Case 24 Eastboro Machine Tools Corporation

Exhibit TN2 (continued)

Setting Dividend-Payout Targets

Case 24 Eastboro Machine Tools Corporation

Exhibit TN2 (continued)

Case 24 Eastboro Machine Tools Corporation

Targeted Dividend Payout

Ending debt (2007)

Initial equity (2000)

Ending equity (2007)

Case 24 Eastboro Machine Tools Corporation

Debt/Equity Ratios by Dividend Payout

Case 24 Eastboro Machine Tools Corporation

Excess Cash (Borrowings)

30 Return on Avg. Equity

Case 24 Eastboro Machine Tools Corporation

Excess Cash (Borrowings)

30 Return on Avg. Equity

Case 24 Eastboro Machine Tools Corporation

Excess Cash (Borrowings)

30 Return on Avg. Equity

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