Case Analysis of GAINESBORO MACHINE TOOLS

CORPORATION (CON): A New Financial Simulation Model

Introduction
In this article, I am willing to introduce you a new financial simulation model which
is based on EXHIBIT 8 (Projected Sources and Uses Statement assuming a 40%
Payout Ratio) of the case: GAINESBORO MACHINE TOOLS CORPORATION. In fact, the
template of this new simulation model is EXHIBIT 8 whereas I have developed this
template by adding new assumptions and new components. I can say that this
simulation model is the combination of Exhibit 8 and Discounted Cash Flow Analysis
plus some new components. The purpose of this simulation model is to analyze
simultaneous impact two independent variables which are the Cost of Capital
(WACC) and Dividend payout ratio on one dependent variable which is the Stock
Price. My final result will be to find the appropriate the Cost of Capital (WACC) and
Terminal Value Growth Rate for two given data in this case which are dividend
payout ratio and the Stock Price. Of course, maybe you think that I should depict
dividend policy which is the issue of the case. Yes, but I will analyze it in my next
article. Here, I will show you that I have still the problem with the calculation WACC
of Gainesboro Machine Tools Corporation. Anyway, I think that I have obtained the
best estimation for WACC.

Methodology
As I told you, I used from EXHIBIT 8 as my template and I entered all data on my
spreadsheet then I did following actions step by step:
Step1: I added below assumptions to Exhibit 8:
Depreciation growth rate
CAPEX growth rate
Change in NWC growth rate
Cost of Capital
Terminal value growth rate
In the result, we will have 8 independent variables.
Step 2: To complete my spreadsheet (template), I should get the growth rate of
CAPEX and Change in NWC and Depreciation growth rate.
Firstly, I checked the amounts obtained from Exhibit 2 (Balance sheet) for CAPEX
and Change in NWC replaced on Exhibit 8 for 2005 year.
Note (1): I can tell you that Change in NWC (19.5) on Exhibit 8 is not true because
we cannot consider Bank loan as current liability. In the meanwhile, the growth rate
of CAPEX for 2009 year had been considered 3.5%!!!!
Please see my true and false calculation as follows:
On the other hand, I calculated CAPEX as follows:
You can see on Exhibit 8 the amount of CAPEX is equal to 43.8 (2005 year) while the
true CAPEX is equal 39.63
I could not find any rational reason behind a 10.5 % increase on CAPEX.
Anyway, if you have any time, you can contact to writers (Robert F. Bruner and Sean
Carr) or publisher (University of Virginia Darden School Foundation, Charlottesville,
VA) about these problems.
Step 3: Following to step 2, I worked on the calculation of the cost of capital and
terminal value growth rate as follows:
Cost of Debt
I considered the cost of debt equal to 4.3% in the reference with Exhibit 3 and Ten
year Treasury note yield of 2004 year.
Cost of Equity
The analysis of the cost of equity in this case is very hard. I use from three methods
as follows:
1) Cost of Equity by using the Constant - Growth Valuation (Gordon) Model. Since
the cost of equity by using of this method is calculated approximately equal to
1.34% which is less than the cost of debt, I assumed the cost of equity more than
4.3%.
2) Using of Stock valuation formula. This method is wrong way
3) The compare shareholders' expected return and cost of debt. In this
method,
I assumed that the cost of equity is always less than the shareholders'
expected return
and more than the cost of debt consequently we have 23% < Ke < 4.3%. I
considered
the average of it as the cost of equity equal to 13%.
Here is my details calculation:
As you can see, finally I considered a range between 4% and 11% for WACC.
One of the most crucial problems to use the discounted cash flow analysis is to find
the appropriate the Terminal Value Growth Rate because this methodology is very
sensitive to TVGR. There are many ways to estimate TVGR as follows:
-Historic growth rates
-Forecast 3- year growth rates
-Terminal capital expenditure
-Competitive advantages among the firms
-Current and future market cap (refer to BGC matrix in Strategic Management)
-Porters five forces such as competitions on barriers to entry
-Macroeconomic indicators such as inflation, interest rate, GDP and so on
The based on Exhibit 3 and the growth rate of CAPEX for final cash flow, I assumed
the range between 0 and 3 for Terminal Value Growth Rate.
Step 4: I have added some components to my simulation model as follows:
-After dividend Excess cash
-Terminal value
-Total excess cash(borrowing )
-Plug: excess cash(borrowing)
-Present value of flows
-Enterprise value
-Borrowing needs
-FV of borrowing needs
-Plug: FV of borrowing needs
-New borrowing needs
- Current outstanding debt
-Total outstanding debt
-Equity value
-Current shares outstanding
-Equity value per share
-Current share price
I used from formula = IF (PLUG < 0, - PLUG, 0) and =IF (PLUG > 0, +PLUG, 0) for
below parameters:
-Plug: excess cash (borrowing)
-Borrowing needs
-Plug: FV of borrowing needs
Here is this part of my simulation model:
Note (2): I think this part of my simulation model is very important for
Macroeconomic analysis because we can examine the risk of deficit financing where
the final cash flow will lead us to a NPV > 0 or a huge economic collapse throughout
the world.
Step 5: In this step, I used two ways table of sensitivity analysis in which I analyzed
the impact of the cost of capital and dividend payout ratio as independent variables
on the stock price as dependent variable. The findings are below cited.
Finding and Discussion
The final result of my sensitivity analysis is as follows:
In the reference with Exhibit 5, the average current stock price of Gainesboro
Machine Tools Corporation is equal $29.15
As you can see on above sensitivity analysis, there are four points which show us
the current situation of Gainesboro as follows:
-WACC = 5% and Dividend payout ratio = 35%
-WACC = 7% and Dividend payout ratio = 20%
- WACC = 9% and Dividend payout ratio = 5%
- WACC = 9% and Dividend payout ratio = 3%
In this analysis, I chose Terminal Value Growth rate equal to 3%.
Now, please look at Exhibit 1 (Income statement). You can see the dividend payout
ratio for 2003 year is equal 35.7%
Dividend payout ratio = Total dividend payout / Net income
Total dividend payout = 0.25 * 18,600,000 = $4,650,000
Net income = 12,993 * 1000 = $12,993,000
Dividend payout ratio = (4,650,000 / 12,993,000) *100 = 35.7%
In the result, I can reserve my assumptions for Terminal Value Growth Rate = 3%
and Cost of Capital = 5 % as my primary data because of current situation of
Gainesboro. As the matter of fact, in my next article, I will explain you how we can
make decision for dividend payout ratio (Dividend Policy) where the basic of our
assumptions for WACC will be equal 5 % and Terminal value growth rate will be
equal 3%.