Eastboro Machine Tools Corporation

Abstract

In mid-September 2001, Jennifer Campbell, the chief financial officer of this large CAD/CAM (computer-aided design and manufacturing) equipment manufacturer must decide whether to pay out dividends to the firm's shareholders, or repurchase stock. If Campbell chooses to pay out dividends, she must also decide on the magnitude of the 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-Modigliani dividend irrelevance theorem and serves to highlight practical considerations in setting dividend policy.

Excerpt

UVA-F-1360

Version 1.1

EASTBORO MACHINE TOOLS CORPORATION

In mid-September of 2001, Jennifer Campbell, chief financial officer (CFO) 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, a policy that 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%, 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 Eastboro's company funds to pay out dividends or to use it 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 had exceeded earnings; then, in 1999, dividends 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.

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Keywords: equity corporate strategy dividend policy growth strategy valuation