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TitleGainesboro Case
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often say that they are repurchasing stock in order to increase earnings per share.

However the authors propose that this assumption is flawed and that shrinking the size of

a firm only adds value if the firm is failing to earn its cost of capital on it’s marginal

investments. In light of this article it is unfortunate that the case does not address the

discount rate or cost of capital.

The case explicitly states that Gainesboro prefers equity to debt financing so it is

reasonable to assume that they initially would seek to issue more stock to finance the

dividend versus borrowing. The company is also very committed and optimistic about its

new Artificial Workforce and it is highly unlikely that fewer investments at this point will

be a chosen option. Based on the companies favored approach in the past, in theory

they’re likely to issue stock (this is based on past assumptions and does not analyze the

signaling consequences of such a decision).

2. What happens to Gainesboro’s financing need and unused debt capacity if:
The numbers outlined below were derived by using the assumptions provided

in the case and making some assumptions of my own. I estimated the cost of

debt (after- tax) to be 6.5% (pre tax 10%) and selected a tax rate 35%

consistent with cases we’ve done in the past. Also I weighted the P/E ratio to

reflect what was stated in the case that 75% of earning would come from new

projects like the Artificial Workforce and 25% would come from the

traditional molds and presses products.

a. no dividends are paid?

If no dividends are paid there is no need for external funds. However this result

does not compensate for negative market response due to the inability to meet the

promise management made to shareholders in the letter the issued in 2004.

Unused debt capacity would be 15.5 million (40% Debt maximum * the

difference between Equity and Debt). EPS is about $0.90 (based on 18.6 million

shares outstanding).

b. a 20% payout is pursued?

At a 20% payout the debt to equity ratio increases to 36.6% and the unused debt

capacity falls to 10.0 million and dividends would require an additional $3.7

million in financing (need). EPS would be $.89 and Dividends would be $.20 per


c. a 40% payout is pursued?

At a 40% payout the D/E ratio increases dramatically to 38.4% way above what

Gainesboro executives would be comfortable with. The financing needed would

be $7.3 million and the unused debt capacity would be a mere 4.6 million. EPS

would be $0.88 and Dividend paid would be $0.39.

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