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PROBLEM STATEMENT In mid September 2001, Jennifer Campbell, the chief financialofficer of Eastboro Machine Tools Corporation, a large

CAD/CAM (computer-aided design andmanufacturing) equipment manufacturer must decide whether to pay out dividends to the firmsshareholders, or repurchase stock. If Campbell chooses to pay out dividends, she must alsodecide on the amount of the payout and how it would affect the company going forward. Anadditional question is whether the firm should embark on a campaign of corporate-imageadvertising and change its corporate name to reflect its new outlook of being a moretechnological company.When considering whether or not it is necessary to pay dividend to shareholders, EastboroMachine Tools Corporation have a problem, the problem is the correct decision andimplementation of Eastboro's dividend policy. In that it has to decide how to provide enoughcash to ensure the upcoming aggressive growth of 15% compounded in the following years. SITUATION ANALYSIS After two massive restructurings, the firm has established itself as anindustry leader in CAM/CAD technology business. Its product being the Artificial Workforceappears to have a bright future. Most of securities analysts are optimistic about the productsimpact on the company. This is why Campbell took the bold approach to assuming that thecompany would grow at a 15% compound rate. For 3 years in a row since 1996, dividends hadexceeded earnings, except in 1999, dividends were decreased to a level below earnings. Despitelosses in 1998 and 2000, small dividend was declared. It has not paid dividend in 2001 althoughit had committed earlier to pay sometime in 2001. DIVIDEND PAYOUT DECISION The dividend decision is part of the firms financing policy.The value of a firm is affected by its dividend policy. The optimal dividend policy is the one thatmaximizes the firm's value. The dividend payout decision which is chosen may affect thecreditworthiness of the firm and therefore the costs of debt and the cost of equity; if the cost of capital changes, so may the value of the firm. Unfortunately, one cannot determine whether thechange in value will be positive or negative without knowing more about the best option of thefirms debt policy.Dividends is considered as a yardstick of a company's prospects and typically,mature, profitable companies pay dividends. If a company with a history of consistently risingdividend payments suddenly cuts its payments, investors normally treat this as a signal that there is possible problem. A steady or increasing dividend is certainly reassuring, but investors areconcerned about companies that rely on borrowings to finance such payments.Retention of profits might lead to excessive executive compensation, sloppy management, andunproductive use of assets, however if there is further investment to be had then retention of profits will be a good option as the management is debt adverse, and believes that 40% is thehighest they will allow in relation to debt to equity ratio. There are several factors to beconsidered when contemplating on the dividend decision: these are clienteles, free cash flow andinformation signalling. These factors are an indication of how shareholders and potentialinvestors judge the company and it also indicates the health of the company as dividend is asignal to the rest of the world as to the future prospects of their, this also tends to lead to adividend policy of a steady, gradually increasing payment. The analysis of the dividend policy ,Firstly the 40% payout ratio is in line with the average industry payout ratio which was 36% inelectrical-industrial equipment and 22% in machine tool industry so declaring 40% dividend will bring Eastboro in line with the current market trend. And it would send a strong signal to theinvestors that the company was confident about it future earnings. However if the companycontinued to pay such high dividends then it will find itself short of cash in future when it has tomake investments in new proposals, especially seeing that there is a deficit for all the years up to2006 after dividend payments. A sensitivity analysis was done using three other payout ratios0%, 10% and 20% they all showed that paying out less than 40% dividend was more

beneficialfor Eastboro with 0% payout being the best option and especially since it is in a new type of business which requires a lot of cash. Investor of companies like institutional value orientedinvestors likes opportunity for value to profit by buying when the share price is deflated, and sothey are advocates for high dividend distribution. So are the short-term trading orientedinvestors. Residual-dividend payout: it is thought that company should pay all the cash leftover after investments in projects with positive Net Present Value; this is declared as residual dividend.Dividend payments tend not to be constant and so could be considered sticky. This means that if the company declares dividend which is less than previous years dividend if stockholders reactnegatively this can affect the share price and the companys image could be hampered. Eastborocould look at this as an option, but only after projects are satisfied. Zero-dividend policy: Eastboro had recently laid emphasis on advanced technologies andCAD/CAM. This needed huge cash for future growth. Since the company belonged to hightechnology and high growth segment it was necessary that it preserves capital for its futureexpansion. Recent studies have shown that the percentage of firms paying dividend hasdecreased. Thus this clearly reflects a growing trend of company retaining its earnings rather than distributing it in the form of dividends. Institutional growth oriented investors prefers company who retain their profits for future growth potential, likewise individual long-termretirement investors, prefers company who retain cash for growth potential.If Eastboro repurchase it stocks the various stakeholders will have confidence and this willindicate that the company is trying to allow the share price to be valuable and so there will be anincrease in the share price, increase EPS and reduction in the dilution of the shares. However thelenders of money will see it as negative as this means that Eastboro would need to borrow torepurchase these shares so increasing their debt ratio. The purpose of this campaign was to enhance the firms visibility and image. It was proposed tochange the name of the company from Eastboro Machine Tools Corporation to EastboroAdvanced Systems International Inc. This would involve a cost of $10 million. It was believedthat the new name would be more consistent with the future products of the company. Also asurvey of financial magazine readers revealed that there was relatively low awareness of Gainesboro and its business. Thus the new advertising campaign will help improve theawareness about the company amongst this segment of people. Recommendation and Implementation Eastboro Machine Tools has recently emphasis more on advanced techniques and CAD/CAMtechnologies. It expects its future growth to come from this particular product and market. Sincethese products belong to the high technology and high growth sector it becomes essential for thecompany to retain cash for future investments or project opportunities. This would be supported by the zero-dividend policy regime. A study was conducted which the percentage of companies paying cash dividends has decreased over the years, this is an indication that dividend payout is becoming a thing of the past. And reflects the growing trend amongst companies of retention of cash for fuelling future growth. The co-founder David Peterboro was against the companyhaving a debt-equity ratio of more than 40%. There is a high possibility that an investment project might be rejected in future due to lack of cash. Thus it becomes essential to retain cash. Conclusion The main issues therefore with dividends are whether they influence the value of the firm, givenits investment decision. As per Modigliani and Miller, the firm should keep retained earningsonly keeping in mind its investment needs. If there are not sufficient investment opportunitiesthen it should pay out the unused funds as dividends.The dividend policy of a firm is irrelevant in a perfect capital market because the shareholder caneffectively undo the firms dividend strategy. If a shareholder receives a greater dividend thandesired, he can

reinvest the excess. On the other hand if he receives less he can sell off his sharesof stock. Even in a perfect capital market a firm should not reject projects with positive cashflows so as to increase the dividends. There is tax benefit to be gained