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Eastboro Case Solution

Case Solution of Eastboro Case

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Eastboro Case Solution

Case Solution of Eastboro Case

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rifki
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© © All Rights Reserved
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Case 24 Version 1.

Eastbo
Eastborr o M achi
achi ne Tool
Tool s Cor
Cor por
por ation
Teaching Note

Synopsis and Objectives

In mid-September 2001, Jennifer Campbell, the chief financial


Other cases in which
officer of this large CAD/CAM (computer-aided design and dividend policy is an
manufacturing) equipment manufacturer must decide whether to pay out important issue:
dividends to the firm’s
firm’s shareholders,
shareholders, or repurchase stock. If Campbell “Deutsche Brauerei”
chooses to pay out dividends, she must also decide on the magnitude of the (case 10).
 payout. A subsidiary question is whether the firm should embark on a
campaign
campai gn of corporate-image
corpor ate-image advertising,
a dvertising, and change its corporate name to
reflect its new outlook. The case serves as an omnibus review of the many practical aspects of the 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-Modigliani1 dividend-irrelevance theorem and serves
to highlight practical considerations in setting dividend policy.

1
Merton Miller
Mil ler and Franco
Franc o Modigliani,
Modigl iani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal
 Journal of
of Busines
Businesss
34 (October 1961): 411-33.

The general problem in this case is modeled upon a much older case by Robert F. Vandell and Pearson Hunt, which has
 been out of print for a number of years. It was believed that students
students today would benefit
benefit from a problem like that, but
with a broader set of policy issues
i ssues cast in a contemporary setting. Despite numerous differences
differences in form and substance
 between the earlier case and this,
t his, the debt to Vandell and Hunt remains large. Vandell was a gracious colleague and
mentor to the authors, who hope this work is a respectful memorial to him. Vandell and Hunt produced no teaching note
for their case. Our understanding of the Vandell-Hunt
Vandell-Hunt case was assisted greatly by notes and comments from from our
colleague
colle ague Professor
Professo r William
Willi am W. Sihler, who edited
edi ted the older
olde r case and reviewed this one. The original version
version of this case
was prepared by Casey Opitz under the the direction of Robert F. Bruner. This teaching note was written
written by Robert F.
Bruner. Copyright © 20012001 by the University
University of Virginia Darden School Foundation, Charlottesville,
Charlottesville, VA. All rights
reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced,
 stored in a retrieval
retrieval system, used in a spreadsheet,
spreadsheet, or transmitted in any form or by any means—electr
means—electronic,
onic, mechanical,
mechanical,
 photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

333
334 Case 24 Eastboro Machine Tools Corporation

Suggested Questions for Advance Assignment to Students

The instructor could assign supplemental reading on dividend policy and share repurchases.
Especially recommended are the Asquith and Mullins article2 on equity signaling, and articles by
Stern Stewart on financial communication.3

1. In theory,
theory, to fund an increased dividend payout
payout or a stock buyback, a firm might
might invest less,
 borrow more, or issue more 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

a. no dividends are paid?


 b. a 20 percent payout is pursued?
c. a 40 percent payout is pursued?
d. a residual payout policy is pursued?

 Note that case Exhibit 8 presents


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.

3. 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
against the zero
 payout, 40 percent
pe rcent 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?

4. How might various providers of capital, such as stockholders and creditors, react
react if
if Eastbor
Eastboro
o
repurchased shares?
shares? Should Eastboro do so?

5. Should Campbell
Campbel l recommend
recomm end the corporate-image advertising campaign and corporate name
change to the directors?
directors? Do the advertising and name change have any bearing on the the
dividend policy or stock repurchase policy
p olicy you propose?

Supporting Computer Spreadsheet Diskfiles

For students: UVA-S-F-1360.XLS


For instructors: UVA-S-F-1360TN.XLS

2
Paul Asquith and David W. Mullins, Jr., “Signaling with Dividends, Stock Repurchases, and Equity Issues,”
 Financial Management  (Autumn
 (Autumn 1986): 27-44.
3
See “How to Communicate
Communicat e with an Efficient
Effi cient Market” and “A Discussion
Discussion of Corporate Financial Communication”
Communication”in
in
 Midland Corporate Finance Journal  2
 2 (Spring 1984).
Case 24 Eastboro Machine Tools Corporation 335

Hypothetical Teaching Plan

1. What are the problems here, and what do you recommend?

The CFO needs to resolve the issue of dividend payout in order to make a recommendation
to the board. She must also decide whether to embark on a stock repurchase program given
the sharp drop in share prices. Nominally, the problems entail setting dividend policy,
deciding on a stock buyback, and resolving the image-advertising campaign issue. But
numerical analysis of the case shows the “problem” includes other factors: setting policy
within a financing constraint, signaling the directors’ outlook, and generally, positioning the
firm’s shares in the equity market.

2. What are the implications of different payout levels for Eastboro’s capital structure and
unused debt capacity?

The discussion here must present the financial implications of high dividend payouts,
 particularly the consumption of unused debt capacity. Because of the cyclicality of demand
or overruns in investment spending, some attention might be given to a sensitivity analysis
over the entire 2001-07 period.

3. What is the nature of the dividend decision Campbell must make, and what are the pros and
cons of the alternative positions? (Or alternatively, Why pay any dividends?) How will
 Eastboro’s various providers of capital, such as stockholders and bankers, react to a
declaration of no dividend? Of a 40 percent payout? Of a “residual” payout?

The instructor needs to elicit the notions that the dividend-payout announcement may affect
stock price and that at least some stockholders prefer dividends. The signaling and clientele
considerations must also be raised.

4. What risks does the firm face?

Discussion following this question should address the nature of the industry, the strategy of
the firm, and the firm’s performance. This discussion will lay the groundwork for the review
of strategic considerations that bear on the dividend decision.

5. What is the nature of the share repurchase decision Campbell must make and how would this
affect the dividend decision?

The discussion here must present the repercussions of a share repurchase decision on the
share price, as well as on the dividend question. Signaling and clientele considerations must
also be considered.
336 Case 24 Eastboro Machine Tools Corporation

6.  Does the stock market appear to reward high dividend payout? Low dividend payout? Does
it matter what type of investor owns the shares? What is the impact of dividend policy on
 share price?

The data can be interpreted to support either view. The point is to show that simple
extrapolations from stock-market data are untrustworthy, largely because of econometric
 problems associated with size and omitted variables (see the Black and Scholes article).4

7. What should Campbell recommend?

Students must synthesize a course of action from the many facts and considerations raised.
The instructor may choose to stimulate the discussion by using an organizing framework
such as FRICT (flexibility, risk, income, control, and timing) on the dividend and share
repurchase issues. The image advertising and name-change issue will be recognized as
another manifestation of the firm’s positioning in the capital markets, and the need to give
effective signals.

The class discussion can end with a vote on the alternatives, followed by a summary of key
 points. Exhibits TN1 and TN2 contain two short technical notes on dividend policy, which the
instructor may either use as the foundation for closing comments or distribute directly to the students
after  the case discussion.

Case Analysis

Eastboro’s asset needs

The company’s investment spending and financing requirements are driven


Discussion
 by ambitious growth goals (a 15 percent annual target is discussed in the case), Question 2
which are to be achieved by a repositioning of the firm—away from its traditional
tools-and-molds business and beyond its CAD/CAM business into a new line of
 products integrating hardware and software—to provide complete manufacturing systems.
CAD/CAM commanded 45 percent of total sales ($340.5 million) in 2000 and is to grow to three-
quarters of sales ($1,509.5 million) by 2007, which implies a 24 percent annual rate of growth in this
 business segment over the subsequent seven years. In addition, international sales are expected to
grow by 37 percent compounded over the subsequent seven years.5 By contrast, the presses-and-
molds segment will grow at about 2.7 percent annually in nominal terms, which implies a negative

4
Fisher Black and Myron Scholes, “The Effects of Dividend Yield and Dividend Policy on Common-Stock Prices
and Returns,” Journal of Financial Economics  1 (1974): 1-22.
5
International sales accounted for 15 percent ($114 million) in 2000. They are expected to account for one-half of
all sales by 2007 (about $1 billion).
Case 24 Eastboro Machine Tools Corporation 337

real rate of growth in what constitutes the bulk of Eastboro’s current business. 6 In short, the
company’s asset needs are driven primarily by a shift in the strategic focus of the company.

Financial implications of payout alternatives

The instructor can guide the students through the financial implications of
various dividend-payout levels either in abbreviated form (for a one-period class) or Discussion
Question 3
in detail (for a two-period class). The abbreviated approach uses the total
cash-flow figures (i.e., for 2001-07) found in the right-hand column of case Exhibit
8. In essence, the approach uses the basic sources and uses of funds identity:

Asset change = New debt + (Profits - Dividends)

With asset additions fixed largely by the firm’s competitive strategy, and with profits
determined largely by the firm’s operating strategy and the environment, the remaining large decision
variables are (1) changes in debt and (2) dividend payout. Even additions to debt are constrained,
however, by the firm’s maximum leverage target, a debt/equity ratio of .40. This framework can be
spelled out for the students to help them envision the financial context.

Exhibit TN3 presents an analysis of the effect of payout on unused debt capacity based on
the projection in case Exhibit 8. The top panel summarizes the firm’s investment program over the
forecast period, as well as financing provided from internal sources. The bottom panel summarizes
the effect of higher payouts on the firm’s financing and unused debt capacity. The principal insight
this analysis yields is that the firm’s unused debt capacity disappears rapidly, and maximum leverage
is achieved as the payout increases. Going from 20 to 40 percent dividend payout (an increase in
cash flow to shareholders of $95 million),7 the company consumes $134 million in unused debt
capacity. Evidently, a multiplier relationship exists between payout and unused debt capacity—every
dollar of dividends paid consumes about $1.408 of debt capacity. The multiplier exists because a
dollar must be borrowed to replace each dollar of equity paid out in dividends, and each dollar of
equity lost sacrifices $.40 of debt capacity that it would have carried.

Whereas the abbreviated approach to analyzing the implications of various dividend-payout


levels considers total 2001-07 cash flows, the detailed approach considers the pattern of the
individual annual cash flows. Exhibit TN4 reveals that, although the debt/equity ratio associated
with the 40 percent payout policy is well under the maximum of 40 in 2007, the maximum is

6
Presses and molds accounted for 55 percent of sales ($416 million) in 2000. By 2007, this segment will account for
about one-quarter of sales ($503 million). The implied compound annual growth rate of 2.7 percent is below the
 projected 3-month Treasury bill rates given in case Exhibit 3, suggesting that the real rate of growth in this segment is
 below zero.
7
The change in cash flow to shareholders is equal to the difference between dividends paid under the 40 percent
 policy ($215 million) and the dividends ($107) and stock buy-back ($12) under the 20 percent policy.
8
Unused debt capacity of $134 ÷ additional dividends paid of $95 results in a ratio of about 1.4.
338 Case 24 Eastboro Machine Tools Corporation

 breached in the preceding years. The graph suggests that a payout policy of 30 percent is about the
maximum that does not breach the debt/equity maximum.

Exhibits TN5 and TN6 reveal some of the financial-reporting and valuation implications of


alternative dividend policies. These exhibits use a simple dividend valuation approach and assume a
terminal value estimated as a multiple of earnings. The analysis is unscientific, as the case does not
contain the information with which to estimate a discount rate based on CAPM.9 The DCF values
show that the firm is slightly more valuable at lower payouts—this is because of the positive impact
on EPS of lower interest costs. However, a better inference would be that the differences are not that
large and that the dividend policy choice in this case has little effect on value. This conclusion is
consistent with the Miller-Modigliani dividend irrelevance theorem.

Regarding the financial-reporting effects of the policy choices, one sees that earnings per
share (line 31) and the implied stock price (line 32) grow more slowly at a 40 percent payout policy
 because of the greater interest expense associated with higher leverage (see line 23). Return on
average equity (line 29) rises with higher leverage, however, as the equity base contracts. The
instructor could use insights such as these to stimulate a discussion of signaling consequences of the
alternative policies, and whether investors even care about performance measures such as EPS and
ROE.10

Risk assessment

 Neither the abbreviated nor detailed forecasts consider adverse deviations


from the plan. Case Exhibit 8 assumes no cyclical downturn over the seven-year Discussion
Question 4
forecast period. Moreover, the model assumes that net margin doubles to 5 percent
and then increases to 8 percent. The company may be able to rationalize these
optimistic assumptions on the basis of its restructuring and the growth of the
Artificial Workforce, but such a material discontinuity in the firm’s performance will warrant careful
scrutiny. Moreover, continued growth may require new-product development after 2002, which may
incur significant research-and-development expenses and reduce net margin.

Students will point out that, so far, the company’s restructuring strategy is associated with
losses (in 1998 and 2000) rather than gains. Although restructuring appears to have been necessary,
the credibility of the forecasts depends on the assessment of management’s ability to begin
harvesting potential profits. Plainly, the Artificial Workforce has the competitive advantage at the
moment, but the volatility of the firm’s performance in the current period is significant: the ratio of
cost of goods sold to sales rose from 61.5 percent in 1999 to 65.9 percent in 2000. Meanwhile, the
ratio of selling, general, and administrative expenses to sales is projected to fall from 30.5 percent in

9
A discount rate of 12 percent is used for illustrative purposes. Presumably, the required return on equity would vary
with the leverage of the firm.
10
These measures are subject to accounting manipulation and are therefore unreliable. However, many operating
executives believe that such measures still retain some influence over the type of equity investors that a firm attracts.
Case 24 Eastboro Machine Tools Corporation 339

2000 to 24.3 percent in 2001. Admittedly, the restructuring accounts for some of this volatility, but
the case suggests several sources of volatility that are external to the company: recession, currency,
new-competitor entry, new-product foul-ups, cost overruns, and surprise acquisition opportunities.

A brief survey of risks invites students to perform a sensitivity analysis of the firm’s
debt/equity ratio under a reasonable downside scenario. Students should be encouraged to exercise
the associated computer spreadsheet model, making modifications as they see fit. Exhibit TN7
 presents a forecast of financial results, assuming a net margin that is smaller than the preceding
forecasts by 1 percent and sales growth at 12 percent rather than 15 percent. This exhibit also
illustrates the implications of a residual dividend policy, i.e., the payment of a dividend only if the
firm can afford it and if the payment will not cause the firm to violate its maximum debt ratios. The
exhibit reveals that, in this adverse scenario, although a dividend payment would be made in 2001,
none would be made in the next two years. Thereafter, the dividend payout would rise. The general
insight remains that the unused debt capacity of Eastboro is relatively fragile and easily exhausted.

The stock-buyback decision

The decision on whether or not to buy back stock should be that, if the Discussion
intrinsic value of Eastboro is greater than its current share price, the shares should be Question 5
repurchased. The case does not provide the information needed to make free cash
flow projections, but one can work around the problem by making some
assumptions. The DCF calculation presented in Exhibit TN8  uses net income as a proxy for
operating income,11 and assumes a WACC of 10 percent, and a terminal value growth factor of 3.5
 percent. The equity value per share comes out to $35.72, representing a 61 percent premium over the
current share price. Based on this calculation, Eastboro should repurchase shares!

However, doing so will not solve Eastboro’s dividend/financing problem. Buying back
shares would further reduce the resources available for a dividend payout. Also, a stock buyback
may be inconsistent with the message Eastboro is trying to convey (i.e., that it is a growth company).
In a perfectly efficient market, it should not matter how investors get their money back (e.g., through
dividends or share repurchases), but in inefficient markets, the role of dividends and buybacks as
signaling mechanisms cannot be disregarded. In Eastboro’s case, we seem to have the case of an
inefficient market; the case suggests that information asymmetries exist between company insiders
and the stock market.

Clientele and signaling considerations

The profile of Eastboro’s equity owners may influence the choice of


dividend policy. Stephen East, the chair of the board and scion of the founders’ Discussion
families and management (who collectively own about 30 percent of the stock), Question 6

11
This violates the rule that free cash flows should reflect prefinancing  cash flows. However, we are not given
any operating income assumptions.
340 Case 24 Eastboro Machine Tools Corporation

seeks to maximize growth in the market value of the company’s stock over time. This goal invites
students to analyze the impact of dividend policy on valuation. Nevertheless, some students might
 point out that, as the population of diverse and disinterested heirs of East and Peterboro grows, the
demand for current income might rise. This naturally raises the question, Who owns the firm? The
stockholder data in case Exhibit 4 show a marked drift over the past 10 years: away from long-term
individual investors and toward short-term traders; and away from growth-oriented institutional
investors and toward value investors. At least a quarter of the firm’s shares are in the hands of
investors who are looking for a turnaround in the not-too-distant future.12 This lends urgency to the
dividend and signaling question.

The case indicates that the board committed itself to resuming a dividend as early as possible
 —“ideally in 2001.” The board’s letter charges this dividend decision with some heavy signaling
implications: because the board previously stated a desire to pay dividends, if it now declares no
dividend investors are bound to interpret the declaration as an indication of adversity. One is
reminded of the Sherlock Holmes story “Silver Blaze,” in which Dr. Watson asks where to look for a
clue:

“To the curious incident of the dog in the night-time,” says Holmes.
“The dog did nothing in the night-time,” Watson answers.
“That was the curious incident,” remarked Sherlock Holmes.13

A failure to signal a recovery might have an adverse impact on share price. In this context, a
dividend—almost any dividend—might indicate to investors that the firm is prospering more or less
according to plan.

Astute students will observe that a subtler signaling problem occurs in the case: what kind of
firm does Eastboro want to signal that it is? Case Exhibit 6 shows that CAD/CAM equipment and
software companies pay low or no dividends, in contrast to electrical machinery manufacturers, who
 pay out one quarter to as much as 60 percent of their earnings. One can argue that, as a result of its
restructuring, Eastboro is making a transition from the latter to the former. If so, the issue becomes
how to tell investors.

The article by Asquith and Mullins14 suggests that the most credible signal about corporate
 prospects is cash, in the form of either dividends or capital gains. Until the Artificial Workforce
 product line begins to deliver significant flows of cash, the share price is not likely to respond
significantly. In addition, any decline in cash flow, caused by the risks listed earlier, would worsen
the anticipated gain in share price. By implication, the Asquith-Mullins work would cast doubt on

12
These “turnaround” investors probably include the value-oriented institutional investors (13 percent of shares) and
the short-term, trading-oriented individual investors (13 percent of shares).
13
From The Memoirs of Sherlock Holmes  by Sir Arthur Conan Doyle.
14
Paul Asquith and David W. Mullins, Jr., “Signaling with Dividends, Stock Repurchases, and Equity Issues,”
 Financial Management  (Autumn 1986): 27-44.
Case 24 Eastboro Machine Tools Corporation 341

corporate image advertising: if cash dividends are what matters, then spending on advertising and a
name change might be wasted.

Stock prices and dividends

Some of the advocates of a high-dividend payout suggest that high stock prices are associated
with high payouts. Students may attempt to prove this point by abstracting from the evidence in case
Exhibits 6 and 7. As we know from academic research (e.g., Friend and Puckett),15 proving the
relationship of stock prices to dividend payouts in a scientific way is extremely difficult. In simple
terms, the reason is because price/earnings (P/E) ratios are probably associated with many factors
that may be represented by dividend payout in a regression model. The most important of these
factors is the firm’s investment strategy; Miller and Modigliani’s 16 dividend-irrelevance theorem
makes the point that the firm’s investments—not the dividends it pays—determine stock prices. One
can just as easily derive evidence of this assertion from case Exhibit 7. The sample of zero-payout
companies has a higher average expected return on capital (13.6 percent) than the sample of high-
 payout companies (average expected return of 10.9 percent); one may conclude that zero-payout
companies have higher returns than high-payout companies and that investors would rather reinvest 
with zero-payout companies than receive a cash payout and be forced to redeploy the capital to
lower-yielding investments.

Decision

The decision at hand is whether Eastboro should buy back stock or Discussion
declare a dividend in the third quarter (although, for practical purposes, students Question 1 and
Closing Vote
will find themselves deciding for all of 2001). As the analysis so far suggests,
the case draws students into a tug-of-war between financial considerations
(which tend to reject dividends and buybacks, at least in the near term) and signaling considerations
(which call for the resumption of dividends at some level, however small). Students will tend to
cluster around three proposed policies: (1) zero payout, (2) low payout (1-10 percent), and (3) a
residual payout scheme calling for dividends when cash is available.

The arguments in favor of zero payout are: (1) the firm is making the transition into the
CAD/CAM industry, where zero payout is the mode; (2) the company should not ignore the financial
statements and act like a blue-chip firm—Eastboro’s risks are large enough without compounding
them by disgorging cash; and (3) the signaling damage already occurred when the directors
suspended the dividend in 2001.

15
Irwin Friend and M. Puckett, “Dividends and Stock Prices,” American Economic Review 54 (September 1964):
656-82.
16
Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,”  Journal of
 Business 34 (October 1961): 411-33.
342 Case 24 Eastboro Machine Tools Corporation

The arguments in favor of a low payout are usually based on optimism about the firm’s
 prospects and on beliefs that Eastboro has sufficient debt capacity, that Eastboro is not exactly a
CAD/CAM firm, and that any dividend that does not restrict growth will enhance share prices.
Usually, the signaling argument is most significant for the proponents of this policy.

The residual policy is a convenient alternative, although it resolves none of the thorny policy
issues in this case. A residual dividend policy is bound to create significant signaling problems as
the firm’s dividend waxes and wanes through each economic cycle.

The question of the image advertising and corporate name change will entice the naive
student as a relatively cheap solution to the signaling problem. The instructor should challenge such
thinking. Signaling research suggests that effective signals are (1) unambiguous and (2) costly. The
advertising and name change, costly as they may be, hardly qualify as unambiguous. On the other
hand, seasoned investor relations professionals believe that advertising and name changes can be
effective in alerting the capital markets to major corporate changes when integrated with other
 signaling devices such as dividends, capital structure, and investment announcements.  The whole
 point of such campaigns should be to gain the attention of “lead steer” opinion leaders.

Overall, inexperienced students tend to dismiss the signaling considerations in this case quite
readily; senior executives and seasoned financial executives, on the other hand, view signaling quite
seriously. If the class votes to buy back stock or declare no dividend in 2001, asking some of the
students to dictate a letter to shareholders explaining the board’s decision may be useful: the difficult
issues of credibility will emerge in a critique of this letter.

If the class does vote to declare a dividend, the instructor can challenge the students to
identify the operating policies they gambled on to make their decision. The underlying question: If
adversity strikes, what will the class sacrifice first: debt, or dividend policies?

Dividend policy is “puzzling,” to use Fisher Black’s term, largely because of its interaction
with other corporate policies and its signaling effect.17 Decisions about the firm’s dividend policy
may be the best way to illustrate the importance of managers’ judgments in corporate finance.
However the class votes, one of the teaching points is that managers are paid to make difficult, even
high-stakes policy choices on the basis of incomplete information and uncertain prospects.

17
Fisher Black, “The Dividend Puzzle,” Journal of Portfolio Management  (Winter 1976): 5-8.
Case 24 Eastboro Machine Tools Corporation 343

Exhibit TN1

EASTBORO MACHINE TOOLS CORPORATION

Supplemental Note: The Dividend Decision and Financing Policy

The dividend decision is necessarily part of the financing policy of the firm. The dividend payout
chosen may affect the creditworthiness of the firm and hence the costs of debt and 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 optimality of the firm’s debt policy. The link between
debt and dividend policies has received little attention in academic circles, largely because of its complexity,
 but remains an important issue for chief financial officers and their advisors. The Eastboro case illustrates the
impact of dividend payout on creditworthiness.

Dividend payout has an unusual multiplier effect on financial reserves. The following table varies the
total 2001-07 sources and uses of funds given in case Exhibit 8, according to different dividend-payout levels.

Targeted Dividend Payout Remarks


0% 20% 40% 50%
 Net Profit $ 537.8 $ 537.8 $ 537.8 $ 537.8
Less dividends   -   107.6   215.1 268.9
Earnings retained   537.8   430.2   322.7 268.9
 New debt (stock buy-back)   (119.3) (11.9) 95.5 149.2
Depreciation   252.0   252.0   252.0 252.0
Increase in assets   670.5   670.3   670.2 670.1

Initial debt (2000)   80.3   80.3   80.3 80.3


Zero if (retained earnings + depreciation) >=
increase in assets; otherwise the difference
Change in debt -   -   95.5 149.2
etween (retained earnings + depreciation) and
(increase in assets)
Ending debt (2007)   80.3   80.3   175.8 229.5

Initial equity (2000)   282.5   282.5   282.5 282.5


Earnings retained   537.8   430.2   322.7 268.9
Zero if (retained earnings + depreciation) <=
increase in assets; otherwise the difference
Stock buyback   (119.3) (11.9) - -
 between (retained earnings + depreciation) and
(increase in assets)
Ending equity (2007)   701.0   700.9   605.2 551.4

Total capital   781.3   781.1   781.0 780.9

Debt/total capital 10.3% 10.3% 22.5% 29.4%


Debt/equity 11.5% 11.5% 29.0% 41.6%

Debt capacity   280.4   280.3   242.1 220.6


(@.4=max debt/equity)
Debt capacity used   80.3   80.3   175.8 229.5
Unused debt capacity   200.1   200.1   66.3 (8.9)
Ratio of debt capacity used to Incremental debt / incremental dividends and
incremental payments to shareholders   1.40 1.40 stock buybacks
344 Case 24 Eastboro Machine Tools Corporation

Exhibit TN1 (continued)

As the table reveals, one dollar of dividends paid consumes $1.40 in unused debt capacity.
At first glance, this result seems surprising—under the sources-and-uses framework, one dollar of
dividend is financed with only one dollar of borrowing. The sources-and-uses reasoning, however,
ignores the erosion in the equity base: a dollar paid out of equity also eliminates $0.40 of debt that
the dollar could have carried. Thus, a multiplier effect exists between dividends and unused debt
capacity whenever a firm borrows to pay dividends.

The choice of dividend payout will affect the probability that the firm will breach its
maximum target leverage. The following figure traces the debt/equity ratios associated with
Eastboro’s dividend-payout ratios.

Debt/Equity Ratios by Dividend Payout

60.0% 0% Payout
  o
   i 50.0%
   t
  a
   R 40.0% 10% Payout
  y
   t
   i 30.0%
  u
  q 20.0% 20% Payout
   E
   /
   t 10.0%
   b
  e 30% Payout
   D 0.0%
-10.0%
40% Payout
   0  1    0
   0
   2    0
   0    3    0  4    0
   0    2   0    2
   5    0
   0    2
   6    0
   0    2   0
   7
   2    2    2
Maximum
 Year 
Debt/Equity

Plainly, the 40 percent dividend-payout ratio violates Eastboro’s maximum debt/equity ratio of 40
 percent.

The conclusion is that, because dividend policy affects creditworthiness, senior managers
should weigh the financial side effects of their payout decisions, along with the signaling,
segmentation, and investment effects, in arriving at a final choice of dividend policy.
Case 24 Eastboro Machine Tools Corporation 345

Exhibit TN2

EASTBORO MACHINE TOOLS CORPORATION

Supplemental Note: Setting Debt and Dividend-Payout Targets

The Eastboro Machine Tools Corporation case illustrates well the challenge of setting the two
most obvious components of financial policy: target payout and debt capitalization. The policies are
linked with the growth target of the firm, as shown in the self-sustainable growth model:

gss = (P/S !*S/A*A/E)(1-DPO)

Where:

gss is the self-sustainable growth rate


P is net income
S is sales
A is assets
E is equity
DPO is dividend-payout ratio

This model describes the rate at which a firm can grow provided that it issues no new shares of
common stock, which describes the behavior or circumstances of virtually all firms. The model
illustrates that the financial policies of a firm are a closed system: growth rate, dividend payout, and
debt targets are interdependent. The model offers the key insight that no financial policy can be set
without reference to the others. As Eastboro shows, a high dividend payout affects the firm’s ability
to achieve growth and capitalization targets and vice versa. Myopic policy—failing to manage the
link among the financial targets—will result in the failure to meet financial targets.

Setting Debt-Capitalization Targets

Finance theory is split on whether gains are created by optimizing the mix of debt and equity
of the firm. Practitioners and many academicians, however, believe that debt optima exist and
devote great effort to choosing the firm’s debt-capitalization targets. Several classic competing
considerations influence the choice of debt targets:
346 Case 24 Eastboro Machine Tools Corporation

Exhibit TN2 (continued)

1. Exploit debt-tax shields. Modigliani and Miller’s theory implies that in a world of taxes,
debt financing creates value.1 Later, Miller theorized that when personal taxes are accounted
for, the leverage choices of the firm might not  create value. So far, the bulk of the empirical
evidence suggests that leverage choices do affect value.

2. Reduce costs of financial distress and bankruptcy. Modigliani and Miller ’s theory naively
implied that firms should lever up to 99 percent of capital. Virtually no firms do this.
Beyond some prudent level of debt, the cost of capital becomes very high because investors
recognize that the firm has a greater probability of suffering financial distress and
 bankruptcy. The critical question then becomes: What is “ prudent”? In practice, two classic
 benchmarks are used:

 Industry-average debt/capital . Many firms lever to the degree practiced by peers, but this
 policy is not very sensible. Industry averages ignore differences in accounting policies,
strategies, and earnings outlooks. Ideally, prudence is defined in firm-specific terms. In
addition, capitalization ratios ignore the crucial fact that a firm goes bankrupt because it runs
out of cash, not because it has a high debt/capital ratio.

 Firm-specific debt service. More firms are setting debt targets on the basis of forecasted
ability to cover principal and interest payments with earnings before interest and taxes
(EBIT). This practice requires forecasting the annual probability distribution of EBIT and
setting the debt-capitalization level so that the probability of covering debt service is
consistent with management’s strategy and risk tolerance.

3. Maintain a reserve against unforeseen adversities or opportunities. Many firms keep their
cash balances and lines of unused bank credit larger than may seem necessary, because
managers want to be able to respond to sudden demands on the firm’s financial resources
caused, for example, by a price war, a large product recall, or an opportunity to buy the
toughest competitor. Academicians have no scientific advice about how large these reserves
should be.

4. Maintain future access to capital. In difficult economic times, less creditworthy borrowers
may be shut out from the capital markets and unable to obtain funds. In the United States,
“less creditworthy” means companies whose debt ratings are less than investment grade (i.e.,
less than BBB2 or Baa3). Accordingly, many firms set debt targets in such a way as to at least
maintain a creditworthy (i.e., investment-grade) debt rating.

1
Actually, value is transferred from the public sector (loss of tax revenue) to the private sector. From a
macroeconomic standpoint, no value has been created.
2
BBB is the lowest investment-grade bond rating awarded by Standard & Poor’s, a bond-rating agency.
Case 24 Eastboro Machine Tools Corporation 347

Exhibit TN2 (continued)

5. Opportunism: exploiting capital-market windows. Some firms’ debt policies vary across the
capital-market cycle. These firms issue debt when interest rates are low (and issue stock
when stock prices are high); they are bargain-hunters (even though no bargains exist in an
efficient market). Opportunism does not explain how firms set targets so much as why firms
deviate from the targets.

Setting Dividend-Payout Targets

In theory, dividend policy should have no effect on the value of a firm’s shares. Nonetheless,
dividend-payout decisions absorb so much of the time of highly paid, bright, senior executives that
dividend payout must be important economically. These are the key considerations that emerge in
 payout decisions:

1. Financing attractive investments. Miller and Modigliani’s famous dividend irrelevance


theory suggests that dividend policy should be set as a residual-that is, the real question to
ask is whether and how the firm can finance all of its positive net-present-value investment
opportunities. Under this view, dividends paid out are simply the cash flow that remains
after a firm makes attractive investments.

2. Sending signals. Executives do not want to tell the world what they foresee for their
companies, because that projection would telegraph their moves to their competitors. Paying
 progressively higher dividends is one way to convey optimism about the future. The
investment community, however, forms its own expectations about the firm’s future and
dividend payments. Dividends have signaling content when they deviate from investors’
expectations:  a surprisingly high or low change in dividend payments conveys news to
investors. Cutting a dividend (even to finance an attractive investment) is universally
 perceived as bad news.

3. Building a reputation. Academic research finds that dividend payments “ratchet” up: they
tend to rise or hold steady, but rarely fall. Many companies advertise their unbroken string of
annual dividend increases. Managers believe that dividend payout builds a reputation of
investment performance.

3
Baa is the lowest investment-grade bond rating awarded by Moody’s Investment Service, a bond-rating agency.
348 Case 24 Eastboro Machine Tools Corporation

Exhibit TN2 (continued)

4. Segmenting the capital market and attracting an investor clientele. If capital markets are not
homogeneous, some investors will pay more for the share of high-payout firms and others
will pay less. From this point of view, chief financial officers should be like consumer
marketers, aiming to position their “product” (e.g., their shares) to the investor clientele that
is willing to pay the most. The firm’s choice of dividend payout may influence the position
of its shares. This view is provocative and not easily implemented for large public
corporations. On the other hand, this consideration is enormously important for privately
owned businesses, because it suggests that managers should listen to the owners’ need s for
cash.

Conclusion

Corporate debt-and-dividend policies emerge after weighing difficult trade-offs among


competing desirable ends. No algorithm or model straightforwardly dictates policies. As analysts
and managers, we confront the need to run the decision process well by ensuring that all trade-offs
surface and all arguments are heard. Ultimately, good policies will meet these three tests:

1. Do they create value?


2. Do they create competitive advantage?
3. Do they sustain the managerial vision?
Case 24 Eastboro Machine Tools Corporation 349

Exhibit TN3

EASTBORO MACHINE TOOLS CORPORATION

Impact of Dividend Payout on Need for External Funds by 2007


(dollars in millions)

Targeted Dividend Payout


0% 20% 40% 50%
 Net Profit $ 537.8 $ 537.8 $ 537.8 $ 537.8
Less dividends   -   107.6   215.1 268.9
Earnings retained   537.8   430.2   322.7 268.9
 New debt (stock buy-back) (119.3) (11.9) 95.5 149.2
Depreciation   252.0   252.0   252.0 252.0
Increase in assets   670.5   670.3   670.2 670.1

Initial debt (2000)   80.3   80.3   80.3 80.3

Change in debt -   -   95.5 149.2

Ending debt (2007)   80.3   80.3   175.8 229.5

Initial equity (2000)   282.5   282.5   282.5 282.5


Earnings retained   537.8   430.2   322.7 268.9

Stock buyback   (119.3) (11.9) - -

Ending equity (2007)   701.0   700.9   605.2 551.4

Total capital   781.3   781.1   781.0 780.9

Debt/total capital 10.3% 10.3% 22.5% 29.4%


Debt/equity 11.5% 11.5% 29.0% 41.6%

Debt capacity   280.4   280.3   242.1 220.6


(@.4=max debt/equity)
Debt capacity used   80.3   80.3   175.8 229.5
Unused debt capacity   200.1   200.1   66.3 (8.9)
Ratio of debt capacity used to
incremental payments to shareholders   1.40 1.40
350 Case 24 Eastboro Machine Tools Corporation

Exhibit TN4

EASTBORO MACHINE TOOLS CORPORATION

Sensitivity Analysis of Debt/Equity Results to Variations in Payout Ratio

Dividend Payout 2001 2002 2003 2004 2005 2006 2007


0% 34.7% 33.4% 27.9% 21.3% 12.4% 6.0% -5.4%
10% 35.6% 35.9% 32.1% 27.0% 19.1% 13.5% 2.3%
20% 36.5% 38.5% 36.6% 33.2% 26.7% 22.1% 11.4%
30% 37.4% 41.2% 41.5% 40.1% 35.2% 32.0% 22.2%
40% 38.3% 44.0% 46.6% 47.7% 45.1% 43.8% 35.4%
Max. D/E Ratio 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%

Debt/Equity Ratios by Dividend Payout

0% Payout
60.0%
  o
   i 50.0%
   t 10% Payout
  a
   R 40.0%
  y
   t
   i 30.0% 20% Payout
  u
  q 20.0%
   E
   /
   t 10.0%
   b 30% Payout
  e
   D 0.0%
-10.0% 40% Payout

   0  1    0
   0
   2    0
   0    0
   3    0  4    0
   0    0
   5    0
   0
   6    0
   0
   7
   2    2    2    2    2    2    2 Maximum
 Year  Debt/Equity

 N.B.: Negative debt/equity ratios imply that the firm has repaid debt and carries excess cash.
Case 24 Eastboro Machine Tools Corporation 351

Exhibit TN5
EASTBORO MACHINE TOOLS CORPORATION
Forecast of Financing Need Assuming 40 Percent Payout1
(dollars in millions)
Common Assumptions
1 Sales Growth 15.0%
2 Net Income Margin 2.1% 4.0% 5.0% 5.5% 6.0% 5.6% 8.0%
3 Dividend Payout 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%
4 Beginning Debt 80.1
5 Beginning Equity 282.5
6 Shares Outstanding 18.3
7 Price Earnings Ratio (2) 33.0
8 Current Market Price $22.15
9 Debt/Equity Maximum 40.0%
10 Borrowing Rate 8.0%
11 Tax Rate 34.0%
Total
2001 2002 2003 2004 2005 2006 2007 2002-07
13 Sales $870.0 $1,000.5 $1,150.6 $1,323.2 $1,521.6 $1,749.9 $2,012.4

Sources:
14 Net Income 18.1 40.0 57.5 72.8 91.3 98.0 160.0 537.7
15 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.0
16 Total Sources 40.6 65.5 87.5 107.3 131.8 144.5 212.5 789.7

Uses:
17 Capital Expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6
18 Working Capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
19 Total Uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

20 Excess Cash (Borrowings) (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6 119.9
21 Dividends 7.2 16.0 23.0 29.1 36.5 39.2 64.0 (215.1)
22 Net (29.9) (23.3) (18.8) (17.6) (7.2) (12.0) 13.6 (95.1)
23 Cumulative Source (Need) (29.9) (53.2) (72.0) (89.6) (96.8) (108.8) (95.1)
24 Int. Cost-New Debt (1.6) (2.8) (3.8) (4.7) (5.1) (5.7) (5.0) (28.8)
25 Net Source (Need) (31.5) (56.0) (75.8) (94.4) (101.9) (114.5) (100.2)
26 Debt (Excess) 111.6 137.7 160.3 182.6 194.9 212.6 204.0 177.4
27 Equity 291.8 313.0 343.7 382.7 432.3 485.4 576.4 511.0
28 Debt/Equity 38.3% 44.0% 46.6% 47.7% 45.1% 43.8% 35.4% 34.7%
29 Unused Debt Capacity 5.1 (12.5) (22.8) (29.6) (22.0) (18.5) 26.5 27.0

30 Return on Avg. Equity 5.8% 12.3% 16.4% 18.7% 21.2% 20.1% 29.2%
31 EPS $0.90 $2.03 $2.93 $3.71 $4.70 $5.03 $8.45
(3)
32 Implied Stock Price $29.71 $66.95 $96.66 $122.42 $155.06 $165.97 $278.79
33 Dividends Per Share $0.39 $0.87 $1.25 $1.59 $1.99 $2.14 $3.49

Return to Investor:
34 Stock Value (Terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $278.79
35 Dividend Received $0.39 $0.87 $1.25 $1.59 $1.99 $2.14 $3.49
36 Total Cap. Apprec. & Divs. ($22.15) $0.39 $0.87 $1.25 $1.59 $1.99 $2.14 $282.28
37 NPV (@ 12%) $98.84
38 Return (IRR) 45.8%

1
The model adds any excess cash flow (which results in negative debt) to the base to calculate unused debt capacity, at a maximum debt/equity ratio of 40%.
2
Weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Eastboro’s targeted business mix, a weight of 75% is assigned to the average P/E of
the CAD/CAM companies, and 25% to the average P/E of the electrical-industrial-equipment and machine-tool manufacturers.
3
EPS times assumed P/E.
352 Case 24 Eastboro Machine Tools Corporation

Exhibit TN6

EASTBORO MACHINE TOOLS CORPORATION

Forecast of Financing Need Assuming 20 Percent Payout1


(dollars in millions)
Common Assumptions
1 Sales Growth 15.0%
2 Net Income Margin 2.1% 4.0% 5.0% 5.5% 6.0% 5.6% 8.0%
3 Dividend Payout 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
4 Beginning Debt 80.1
5 Beginning Equity 282.5
6 Shares Outstanding 18.3
(2)
7 Price Earnings Ratio 33.0
8 Current Market Price $22.15
9 Debt/Equity Maximum 40.0%
10 Borrowing Rate 8.0%
11 Tax Rate 34.0%
Total
2001 2002 2003 2004 2005 2006 2007 2002-07
13 Sales $870.0 $1,000.5 $1,150.6 $1,323.2 $1,521.6 $1,749.9 $2,012.4

Sources:
14 Net Income 18.1 40.0 57.5 72.8 91.3 98.0 160.0 537.7
15 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.0
16 Total Sources 40.6 65.5 87.5 107.3 131.8 144.5 212.5 789.7

Uses:
17 Capital Expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6
18 Working Capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
19 Total Uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

20 Excess Cash (Borrowings) (22.7) (7.3) 4.2 11.5 29.4 27.2 77.6 119.9
21 Dividends 3.6 8.0 11.5 14.6 18.3 19.6 32.0 (107.5)
22 Net (26.3) (15.3) (7.3) (3.0) 11.1 7.6 45.6 12.4
23 Cumulative Source (Need) (26.3) (41.6) (48.9) (51.9) (40.8) (33.2) 12.4
24 Int. Cost-New Debt (1.4) (2.2) (2.6) (2.7) (2.2) (1.8) 0.7 (12.2)
25 Net Source (Need) (27.7) (43.8) (51.5) (54.7) (43.0) (35.0) 13.1
26 Debt (Excess) 107.8 125.3 135.2 140.9 132.0 126.1 79.9 53.3
27 Equity 295.6 325.4 368.9 424.4 495.2 571.9 700.5 618.6
28 Debt/Equity 36.5% 38.5% 36.6% 33.2% 26.7% 22.1% 11.4% 8.6%
29 Unused Debt Capacity 10.4 4.9 12.4 28.8 66.1 102.6 200.3 194.2

30 Return on Avg. Equity 5.8% 12.2% 15.8% 17.7% 19.4% 18.0% 25.2%
31 EPS $0.91 $2.06 $3.00 $3.82 $4.86 $5.25 $8.76
(3)
32 Implied Stock Price $30.06 $68.05 $98.86 $126.00 $160.38 $173.15 $289.01
33 Dividends Per Share $0.20 $0.44 $0.63 $0.79 $1.00 $1.07 $1.74

Return to Investor:
34 Stock Value (Terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $289.01
35 Dividend Received $0.20 $0.44 $0.63 $0.79 $1.00 $1.07 $1.74
36 Total Cap. Apprec. & Divs. ($22.15) $0.20 $0.44 $0.63 $0.79 $1.00 $1.07 $290.75
37 NPV (@ 12%) $99.96
38 Return (IRR) 45.4%

1
The model adds any excess cash flow (which results in negative debt) to the base to calculate unused debt capacity, at a maximum debt/equity ratio of 40%.
2
Weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Eastboro’s targeted business mix, a weight of 75% is assigned to the average P/E of
the CAD/CAM companies, and 25% to the average P/E of the electrical-industrial-equipment and machine-tool manufacturers.
3
EPS times assumed P/E.
Case 24 Eastboro Machine Tools Corporation 353

Exhibit TN7
EASTBORO MACHINE TOOLS CORPORATION
Forecast of Financing Need Assuming Residual Dividend Policy,
Lower Growth, and Lower Margins1
(dollars in millions)
Common Assumptions
1 Sales Growth 12.0%
2 Net Income Margin 1.1% 3.0% 4.0% 4.5% 5.0% 4.6% 7.0%
3 Dividend Payout 21.3% 0.0% 0.0% 4.8% 28.9% 21.3% 45.4%
4 Beginning Debt 80.1
5 Beginning Equity 282.5
6 Shares Outstanding 18.3
(2)
7 Price Earnings Ratio 33.0
8 Current Market Price $22.15
9 Debt/Equity Maximum 40.0%
10 Borrowing Rate 8.0%
11 Tax Rate 34.0%
Total
2001 2002 2003 2004 2005 2006 2007 2002-07
13 Sales $870.0 $974.4 $1,091.3 $1,222.3 $1,369.0 $1,533.2 $1,717.2

Sources:
14 Net Income 9.4 29.2 43.7 55.0 68.4 70.5 119.3 395.6
15 Depreciation 22.5 25.5 30.0 34.5 40.5 46.5 52.5 252.0
16 Total Sources 31.9 54.7 73.7 89.5 108.9 117.0 171.8 647.6

Uses:
17 Capital Expenditures 43.8 50.4 57.5 66.2 68.5 78.8 90.6
18 Working Capital 19.5 22.4 25.8 29.6 34.0 38.5 44.3
19 Total Uses 63.3 72.8 83.3 95.8 102.4 117.3 134.9 669.8

20 Excess Cash (Borrowings) (31.4) (18.1) (9.7) (6.3) 6.5 (0.2) 37.0 -22.1
21 Dividends 2.0 0.0 0.0 2.6 19.8 15.0 54.1 (93.6)
22 Net (33.4) (18.1) (9.7) (8.9) (13.3) (15.3) (17.2) (115.7)
23 Cumulative Source (Need) (33.4) (51.5) (61.1) (70.0) (83.3) (98.5) (115.7)
24 Int. Cost-New Debt (1.8) (2.7) (3.2) (3.7) (4.4) (5.2) (6.1) (27.1)
25 Net Source (Need) (35.2) (54.2) (64.4) (73.7) (87.7) (103.8) (121.8)
26 Debt (Excess) 115.3 136.0 149.0 161.5 179.2 199.7 222.9 196.3
27 Equity 288.2 314.7 355.1 403.8 448.1 498.4 557.5 490.4
28 Debt/Equity 40.0% 43.2% 41.9% 40.0% 40.0% 40.1% 40.0% 40.0%
29 Unused Debt Capacity (0.0) (10.2) (6.9) (0.0) 0.0 (0.3) 0.1 (0.1)

30 Return on Avg. Equity 2.7% 8.8% 12.1% 13.5% 15.0% 13.8% 21.4%
31 EPS $0.42 $1.45 $2.20 $2.80 $3.49 $3.56 $6.17
(3)
32 Implied Stock Price $13.73 $47.70 $72.73 $92.31 $115.24 $117.53 $203.73
33 Dividends Per Share $0.11 $0.00 $0.00 $0.14 $1.08 $0.82 $2.95

Return to Investor:
34 Stock Value (Terminal) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $203.73
35 Dividend Received $0.11 $0.00 $0.00 $0.14 $1.08 $0.82 $2.95
36 Total Cap. Apprec. & Divs. ($22.15) $0.11 $0.00 $0.00 $0.14 $1.08 $0.82 $206.68
37 NPV (@ 12%) $64.78
38 Return (IRR) 38.0%

1
The model adds any excess cash flow (which results in negative debt) to the base to calculate unused debt capacity, at a maximum debt/equity ratio of 40%.
2
Weighted average of comparable company PE ratios given in case Exhibit 6. Reflecting Eastboro’s targeted business mix, a weight of 75% is assigned to the average P/E of
the CAD/CAM companies, and 25% to the average P/E of the electrical-industrial-equipment and machine-tool manufacturers.
3
EPS times assumed P/E.

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