Corporate Goals - Zero-dividend Payout - Eastboro Machine Tools Corporation - Accounting Assignment Help

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Task: EASTBORO MACHINE TOOLS CORPORATION In mid-September of 2001, Jennifer Campbell, chief financial officer of Eastboro Machine Tools Corporation, paced the floor of her Minnesota office. She needed to submit a recommendation to Eastboro’s board of directors regarding the company’s dividend policy, which had been the subject of an ongoing debate among the firm’s senior managers. Compounding her problem was the previous week’s terrorist attacks on the World Trade Center and the Pentagon. The stock market had plummeted in response to the attacks, and along with it Eastboro’s stock had fallen 18 percent, to $22.15. In response to the market collapse, a spate of companies had announced plans to buy back stock, some to signal confidence in their companies as well as in the U.S. financial markets, and others for opportunistic reasons. Now Jennifer Campbell’s dividend-decision problem was compounded by the dilemma of whether to use company funds to pay out dividends or to buy back stock instead. BACKGROUND ON THE DIVIDEND QUESTION After years of traditionally strong earnings and predictable dividend growth, Eastboro had faltered in the past five years. In response, management implemented two extensive restructuring programs, both of which were accompanied by net losses. For three years in a row since 1996, dividends were decreased to a level below earnings. Despite extraordinary losses in 2000, the board of directors had declared a small dividend. For the first two quarters of 2001, the board had declared no dividend. But in a special letter to shareholders, the board had committed itself to resuming the dividend as early as possible – ideally in 2001. In a related matter, senior management was considering embarking on a campaign of corporate-image advertising along with changing the name of the corporation to “Eastboro Advanced Systems International, Inc.” Management felt that this would help improve the perception of the company in the investment community. Overall, management’s view was that Eastboro was a resurgent company that demonstrated great potential for growth and profitability. The restructurings had revitalized the company’s operating divisions. In addition, newly developed machine tools designed on state-of-art computers showed signs of being well received in the market and promised to render competitors’ products obsolete. Many within the company viewed 2001 as the dawning of a new era that, in spite of the company’s recent performance, would turn Eastboro into a growth stock. The company had no Mood’s or Standard & Poor’s rating because it had no bonds outstanding, but Value Line rated it an “A” company. Out of this combination of a troubled past and a bright future arose Campbell’s dilemma. Did the market view Eastboro as a company on the wane, a blue-chip stock, or a potential growth stock? How, if at all, could Eastboro affect that perception? Would a change of name help frame investors’ views of the firm? Did the company’s investors expect capital growth or steady dividends? Would a stock buyback instead of a dividend affect investor’s perceptions of Eastboro in any way? And, if those questions could be answered, what were the implications for Eastboro’s future dividend policy? THE COMPANY Eastboro Corporation was founded in 1923 in Concord, New Hampshire, by two mechanical engineers, James East and David Peterboro. The two men had gone to school together and were disenchanted with their prospects as mechanics at a farm-equipment manufacturer. In its early years, Eastboro had designed and manufactured a number of machinery parts, including metal presses, dies, and molds. In the 1940’s the company’s large manufacturing plant produced tank and armoured-vehicle parts and miscellaneous equipment for the war effort, including riveters and welders. After the war, the company concentrated on the production of industrial presses and molds, for plastics as well as metals. By 1975, the company had developed a reputation as an innovative producer of industrial machinery and machine tools. In the late 1970’s Eastboro entered the new field of computer-aided design and computer-aided manufacturing (CAD/CAM). Working with a small software company, it developed a line of presses that would manufacture metal parts by responding to computer commands. Eastboro merged the software company into its operations and, over the next several years, perfected the CAM equipment. At the same time, it developed a superior line of CAD software and equipment that would allow an engineer to design a part to exacting specifications on a computer. The design could then be entered into the company’s CAM equipment, and the parts would be manufactured without the use of blueprints or human interference. By year-end 2000, CAD/CAM equipment and software were responsible for about 45 percent; and miscellaneous machine tools for 15 percent. Most press and mold companies were small local or regional firms with limited clientele. For this reason, Eastboro stood out as a true industry leader Within the CAD/CAM industry, however, a number of larger firms, including General Electric, Hewlett-Packard, and Digital Equipment, competed for dominance of the growing market. Throughout the 1980’s Eastboro helped set the standard for CAD/CAM, but the aggressive entry of large foreign firms into CAD/CAM and the rise of the dollar dampened sales. In the mid-to-late 1990’stechnological advances and aggressive venture capitalism fuelled the entry of highly specialized, state-of-the-art CAD/CAM firms. Eastboro fell behind some of its competition in the development of user-friendly software and the integration of design and manufacturing. As a result, revenues declined from a high of $911 million in 1994 to $757 million in 2000. To combat the decline in revenues and improve weak profit margins, Eastboro took a two-pronged approach. First, it devoted a greater share of its research-and-development budget to CAD/CAM in an effort to re-establish leadership in the field. Second, the company underwent two massive restructurings. In 1998, it sold two unprofitable lines of business with revenues of $51 million, sold two plants, eliminated five leased facilities, and reduced personnel. Restructuring costs totalled $65 million. Then, in 2000, the company began a second round of restructuring by altering its manufacturing strategy, refocusing its sales and marketing approach, and adopting administrative procedures that allowed for a further reduction in staff and facilities. The total cost of the operational restructuring in 2000 was $89 million. The company’s recent income statements and balance sheets are provided in Exhibits 1 & 2. Although the two restructurings produced losses totalling $202 million in 1998 and 2000, by 2001 the restructurings and the increased emphasis on CAD/CAM research appeared to have launched a turnaround. Not only was the company leaner, but also the CAD/CAM research led to the development of a system that Eastboro management believed would redefine the industry. Known as the Artificial Workforce, the system was an array of advanced control hardware, software, and applications that could distribute information throughout a plant. Essentially, the Artificial Workforce allowed an engineer to design a part on the CAD software and input data into a CAM that could control the mixing of chemicals or the molding of parts from any number of different materials on different machines. The system could also assemble and can, box, or shrink-wrap the finished product. The Artificial Workforce ran on complex circuitry and highly advanced software that allowed machines to communicate with each other electronically. Thus, no matter how intricate, a product could be designed, manufactured, and packaged solely by computer. Eastboro had developed applications of the product for the oil-and-gas-refining and chemicals industries in 2000, and by the next year was developing applications for the trucking, automobile-parts, and airline industries. By October 2000, when the first Artificial Workforce was shipped, Eastboro had orders totalling $475 million; by year-end, the backlog totalled $100 million. The future for the product looked bright. Several securities analysts were optimistic about the product’s impact n the company. The following comments paraphrase their thoughts: The Artificial Workforce products have compelling advantages over competing entries and will enable Eastboro to increase its share of a market that, ignoring periodic growth spurts, will expand at a real annual rate of about 5 percent over the next several years.  The company is producing the Artificial Workforce in a new automated facility which, when in full swing, will help restore margins to levels not seen for years. The important question now is how quickly Eastboro will be able to ship in volume. Manufacturing foul-ups and missing components have delayed production growth through May 2001, about six months beyond the original target date. And start-up costs, which were a significant factor in last year’s deficits, have continued to penalize earnings. Our estimates assume that production will proceed smoothly from now on and that it will approach the optimum level by year’s end. Eastboro management expected domestic revenues from the Artificial Workforce series to total $990 million in 2001 and $150 million in 2002. Thereafter, growth in sales would depend on the development of more system applications and the creation of system improvements and add-on features. International sales through Eastboro’s existing offices in Frankfurt, London, Milan, and Paris, and new offices in Hong Kong, Seoul, Manila, and Tokyo, were expected to provide additional revenues of $150 million as early as 2003. Currently, international sales accounted for about 15 percent of total corporate revenues. Two factors that could affect sales were of some concern to Eastboro. First, although the company had successfully patented several of the processes used by the Artificial Workforce system, management had received hints through industry observers that two strong competitors were developing comparable products and would probably introduce them within the next 12 months. Second, sales of molds, presses, machine tools, and CAD/CAM equipment and software were highly cyclical, and current predictions about the strength of the U.S. economy were not encouraging. As shown in Exhibit 3, real GDP growth was expected to slow to 1.6 percent this year from around 4 percent over the past three years. Industrial production was expected to decline by 2.5 percent. Despite the macroeconomic environment, Eastboro management remained optimistic about the company’s prospects because of the successful introduction of the Artificial Workforce. CORPORATE GOALS A number of corporate objectives had grown out of the restructurings and recent technological advances. First and foremost, management wanted and expected the firm to grow at an average annual compound rate of 15 percent. A great deal of corporate planning had been devoted to that goal over the past three years and, indeed, second-quarter financial data suggested that Eastboro would achieve revenues of about $870 million in 2001, as shown in Exhibit 1. If Eastboro achieved a 15 percent compound rate of growth throughout 2007, the company would reach $2.0 billion in sales and $160 million in net income. In order to achieve this growth goal, Eastboro management proposed a strategy relying on three key points. First, the mix of production would shift substantially. CAD/CAM and peripheral products on the cutting edge of industry technology would account for three quarters of sales; the company’s traditional presses and molds would account for the remainder. Second, the company would expand aggressively internationally, where it hoped to obtain half of its sales and profits by 2007. This expansion would be achieved through opening new field sales offices around the world. Third, the company would expand through joint ventures and acquisitions of small software companies, which would provide one-half of the new products through 2007; internal research would provide the other half. From its beginning, Eastboro had an aversion to debt. Management believed that small amounts of debt, primarily to meet working-capital needs, had its place, but that anything beyond a 40 percent debt-to-equity ratio was, in the oft-quoted words of cofounder David Peterboro, “unthinkable, indicative of sloppy management, and flirting with trouble.” Senior management was aware that equity was typically more costly that debt, but took great satisfaction in the company “doing it on its own”. Eastboro’s highest debt-to-capital ratio in the past 25 years – 22 percent – occurred in 2000, and was still the subject of conversations among senior managers. Although 11 members of the East and Peterboro families owned 30 percent of the company’s stock and three were on the board of directors, management placed the interests of the public shareholders first. (Shareholder data are provided in Exhibit 4). Stephen East, chairman of the board and grandson of the cofounder, sought to maximize the growth in the market value of the company’s stock over time. At the age of 61, East was actively involved in all aspects of the company’s growth and future. He was conversant with a range of technical details of Eastboro’s products and was especially interested in finding ways to improve the company’s domestic-market share. His retirement was no more than four years into the future, and he wanted to leave a legacy of corporate financial strength and technological achievement. The Artificial Workforce, a project he had taken under his wing four years earlier, was beginning to bear fruit. He now wanted to ensure that the firm would also soon be able to pay a dividend. East took particular pride in selecting and developing young managers with promise. Campbell had a bachelor’s degree in electrical engineering and had been a systems analyst for Motorola before attending graduate school. She had been hired in 1991 out of a well-known MBA program. By 2000, she had risen to the position of chief financial officer. DIVIDEND POLICY Eastboro’s dividend and stock-price histories are presented in Exhibit 5. Prior to 1995, both earnings and dividends per share had grown at a relatively steady pace, but Eastboro’s troubles in the mid-to-late 1990’s took their toll on earnings. As a consequence, dividends were pared back in 1999 to $0.25 a share – the lowest dividend since 1986. In 2000, the board of directors declared a payout of $0.25 a share despite reporting the largest per-share earnings loss in the firm’s history, and, in effect, borrowing to pay the dividend. In the first two quarters of 2001, the directors had not declared a dividend. In a special letter to shareholders, however, the directors declared their intention to continue the annual payout later in 2001. In August 2001, Campbell contemplated choosing among three possible dividend policies to recommend:

• Zero-dividend payout.

This option could be justified in light of the firm’s strategic emphasis on advanced technologies and CAD/CAM, and reflected the huge cash requirements of that move. The proponents of this policy argued that it would signal that the firm belonged in a class of high-growth and high-technology firms. Some securities analysts wondered whether the market still considered Eastboro a traditional electrical-equipment manufacturer or a more technologically advanced CAD/CAM company. The latter category would imply that the market was expecting strong capital appreciation but, perhaps, little in the way of dividends. Others cited Eastboro’s recent performance problems. One questioned the “wisdom of ignoring the financial statements in favour of acting like a blue chip.” Was a high dividend in the long-term interests of the company and its stockholders, or would the strategy backfire and make investors skittish? Campbell recalled a recently published study that found that firms were displaying a lower propensity to pay dividends. The study found that the percentage of firms paying cash dividends had dropped from 66.5 in 1978 to 20.8 in 1999. In this light, perhaps the market would not react unkindly if Eastboro assumed a zero-dividend-payout policy.

• 40 percent dividend payout or a dividend of around $0.20 a share.

This would restore the firm to an implied annual dividend payment of $0.80 a share, the highest since 1997. Proponents of this policy argued that there was undoubtedly some anticipation of such an announcement in the current stock price of $32 a share, and that this was justified by expected increases in orders and sales. Eastboro’s investment banker suggested that the market might be expecting a strong dividend in order to bring the payout back in line with the 45 percent average within the electrical-industrial-equipment industry and with the 29 percent average in the machine-tool industry. Still others believed that it was important to send a strong signal to shareholders, and that a large dividend (on the order of a 40 percent payout) would suggest that the company had conquered its problems and that its directors were confident of future earnings. Supporters of this view argued that borrowing to pay dividends was not inconsistent with the behaviour of most firms. Finally, some older members of management opined that a growth rate in the range of 10 to 20 percent should accompany a payout of 30 to 50 percent.

• Campbell remembered reading a Wall Street Journal article only a few days earlier in which the columnist had argued that with the recent collapse in technology and other growth stocks, investors were flocking to dividend-paying stocks. The article quoted Jeremy Siegel, a finance professor at the Wharton School: “A little more than a year ago, people laughed at dividends…. In the future, I believe that more attention will be paid to dividends and current earnings and less to growth.”
• Residual-dividend-payout policy.

A few members of the finance staff argued that Eastboro should pay dividends only after funding all projects offering positive net present values (NPVs).  Their view was that investors were paying managers to deploy their funds at returns better than they could achieve otherwise and that, by definition, such investments would yield positive NPVs. By deploying funds into these projects and otherwise returning unused funds to investors in the form of dividends, the firm would build trust with investors and be rewarded with higher valuation multiples. General Motors was the pre-eminent example of a firm that had followed such a policy, though few large publicly held firms followed its example.

• Another argument in support of this view was that dividend policy was “irrelevant” in a growing firm; any dividend paid today would be offset by dilution at some future date by the issue of shares necessary to make up for the dividend. This argument reflected the theory of dividends in a perfect market advanced by two finance professors, Merton Miller and Franco Modigliani. The main disadvantage of this policy to Jennifer Campbell was that dividend payments would be unpredictable. In some years, dividends could be cut – even to zero – possibly imposing negative pressure on the firm’s share price. Campbell was all too aware of Eastboro’s own share-price collapse following its dividend cut. She recalled a study by another finance professor, John Lintner, which found that firms’ dividend payments tended to be “sticky” upward – that is, dividends would rise over time and rarely fall, and that mature slower-growth firms paid higher dividends, while high-growth firms paid lower dividends.

In response to this internal debate, Campbell’s staff pulled together Exhibits 6 and 7, which present comparative information on companies in three industries – CAD/CAM machine tools, and electrical-industrial equipment – and on a general sample of high-and-low-payout companies. To test the feasibility of a 40 percent dividend payout rate, Campbell developed the projected sources and uses of cash provided in Exhibit 8. She took the boldest approach by assuming that the company would grow at a 15 percent compound rate, that margins would improve over the next few years to historical levels, and that the firm would pay a dividend of 40 percent of earnings every year. In particular, the forecast assumed that the firm’s net margin would hover between 4 and 6 percent over the next six years, and then increase to 7.95 percent in 2007. The firm’s operating executives believed that this increase in profitability was consistent with economies of scale to be achieved upon the attainment of higher operating output of the Artificial Workforce. IMAGE ADVERTISING AND NAME CHANGE As part of a general review of the firm’s standing in the financial markets, Eastboro’s director of Investor Relations, Cathy Williams, had concluded that investors misperceived the firm’s prospects and that the firm’s current name was more consistent with the firm’s historical product mix and markets than with those expected in the future. Williams commissioned surveys of readers of financial magazines, which revealed a relatively low awareness of Eastboro or its business. Surveys of stockbrokers revealed higher awareness of the firm, but a low or mediocre outlook on Eastboro’s likely returns to shareholders and growth prospects. Williams retained a consulting firm that recommended a program of corporate “image” advertising targeted toward opinion-leading institutional investors and individual investors. The objective was to enhance the awareness and image of Eastboro. Through focus groups, the consultants identified a name that appeared to suggest the firm’s promising strategy: “Eastboro Advanced Systems International, Inc.” Williams estimated that the image-advertising campaign and name change would cost approximately $10 million. Stephen East was mildly sceptical. He said, “Do you mean to raise our stock price by “marketing” our shares? This is a novel approach. Can you sell claims on a company the way Procter & Gamble markets soap?” The consultants could give no empirical evidence that stock prices responded favourably to corporate-image campaigns or name changes, though they did offer some favourable anecdotes. CONCLUSION Jennifer Campbell was caught in a difficult position. Members of the board and management disagreed on the very nature of Eastboro’s future. Some managers saw the company as entering a new stage of rapid growth and thought that a large (or in the minds of some, any) dividend would be inappropriate. Others thought that it was important to make a strong gesture to the public that management believed Eastboro had turned the corner and was about to return to the levels of growth and profitability seen in the 1970’s and ‘80s. This action could only be accomplished through a dividend. Then there was the confounding question about the stick buyback: should Eastboro use funds to repurchase stocks instead of paying out a dividend? As she wrestled with the different points of view, she wondered whether management might be representative of the company’s shareholders. Did the majority of public shareholders own stock for the same reason, or were their reasons just as diverse as those of management? Required:

1. In theory, to fund an increased dividend payout or a stock buyback, a firm might invest less, borrow more, or issue 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
   1. no dividends are paid?
   2. a 20 percent payout is pursued?
   3. a 40 percent payout is pursued?
   4. a residual payout policy is pursued?

Note that 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.

1. 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?
2. How might various providers of capital, such as stockbrokers and creditors, react if Eastboro repurchased shares?  Should Eastboro do so?
3. Should Campbell recommend the corporate-image advertising campaign and corporate name change to the directors?  Do the advertising and name changes have any bearing on the dividend policy or stock repurchase policy you propose?

In all parts, show all calculations and justify any assumptions you make.

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