MEMORANDUM

TO: Board of directors

FROM: Chief Financial Officer

Date: February 7, 2011

SUBJECT: DIVIDEND POLICY DECISION

PROBLEM STATEMENT In mid September 2001, Jennifer Campbell, the chief financial
officer of Eastboro Machine Tools Corporation, a 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 amount of the payout and how it would affect the company going forward. An
additional question is whether the firm should embark on a campaign of corporate-image
advertising and change its corporate name to reflect its new outlook of being a more
technological company.
When considering whether or not it is necessary to pay dividend to shareholders, Eastboro
Machine Tools Corporation have a problem, the problem is the correct decision and
implementation of Eastboro's dividend policy. In that it has to decide how to provide enough
cash 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 an
industry leader in CAM/CAD technology business. Its product being the “Artificial Workforce”
appears to have a bright future. Most of securities analysts are optimistic about the product’s
impact on the company. This is why Campbell took the bold approach to assuming that the
company would grow at a 15% compound rate. For 3 years in a row since 1996, dividends had
exceeded earnings, except in 1999, dividends were decreased to a level below earnings. Despite
losses in 1998 and 2000, small dividend was declared. It has not paid dividend in 2001 although
it had committed earlier to pay sometime in 2001.

DIVIDEND PAYOUT DECISION The dividend decision is part of the firm’s financing policy.
The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that
maximizes the firm's value. The dividend payout decision which is chosen may affect the
creditworthiness 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 the
change in value will be positive or negative without knowing more about the best option of the
firm’s 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 rising
dividend payments suddenly cuts its payments, investors normally treat this as a signal that there

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is possible problem. A steady or increasing dividend is certainly reassuring, but investors are
concerned about companies that rely on borrowings to finance such payments.

Retention of profits might lead to excessive executive compensation, sloppy management, and
unproductive 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 the
highest they will allow in relation to debt to equity ratio. There are several factors to be
considered when contemplating on the dividend decision: these are clienteles, free cash flow and
information signalling. These factors are an indication of how shareholders and potential
investors judge the company and it also indicates the health of the company as dividend is a
signal to the rest of the world as to the future prospects of their, this also tends to lead to a
dividend 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% in
electrical-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 the
investors that the company was confident about it future earnings. However if the company
continued to pay such high dividends then it will find itself short of cash in future when it has to
make investments in new proposals, especially seeing that there is a deficit for all the years up to
2006 after dividend payments. A sensitivity analysis was done using three other payout ratios
0%, 10% and 20% they all showed that paying out less than 40% dividend was more beneficial
for 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 oriented
investors likes opportunity for value to profit by buying when the share price is deflated, and so
they are advocates for high dividend distribution. So are the short-term trading oriented
investors.

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 year’s dividend if stockholders react
negatively this can affect the share price and the company’s image could be hampered. Eastboro
could look at this as an option, but only after projects are satisfied.

Zero-dividend policy: Eastboro had recently laid emphasis on advanced technologies and
CAD/CAM. This needed huge cash for future growth. Since the company belonged to high
technology and high growth segment it was necessary that it preserves capital for its future
expansion. Recent studies have shown that the percentage of firms paying dividend has
decreased. 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

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company who retain their profits for future growth potential, likewise individual long-term
retirement investors, prefers company who retain cash for growth potential.

If Eastboro repurchase it stocks the various stakeholders will have confidence and this will
indicate that the company is trying to allow the share price to be valuable and so there will be an
increase in the share price, increase EPS and reduction in the dilution of the shares. However the
lenders of money will see it as negative as this means that Eastboro would need to borrow to
repurchase these shares so increasing their debt ratio.

The purpose of this campaign was to enhance the firm’s visibility and image. It was proposed to
change the name of the company from Eastboro Machine Tools Corporation to Eastboro
Advanced Systems International Inc. This would involve a cost of $10 million. It was believed
that the new name would be more consistent with the future products of the company. Also a
survey of financial magazine readers revealed that there was relatively low awareness of
Gainesboro and its business. Thus the new advertising campaign will help improve the
awareness about the company amongst this segment of people.

Recommendation and Implementation

Eastboro Machine Tools has recently emphasis more on advanced techniques and CAD/CAM
technologies. It expects its future growth to come from this particular product and market. Since
these products belong to the high technology and high growth sector it becomes essential for the
company 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 company
having 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, given
its investment decision. As per Modigliani and Miller, the firm should keep retained earnings
only keeping in mind its investment needs. If there are not sufficient investment opportunities
then 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 can
effectively undo the firm’s dividend strategy. If a shareholder receives a greater dividend than
desired, he can reinvest the excess. On the other hand if he receives less he can sell off his shares
of stock. Even in a perfect capital market a firm should not reject projects with positive cash
flows so as to increase the dividends. There is tax benefit to be gained from low dividend payout.

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.