As a young adult in her mid-twenties, Deanna Perez emigrated from Spain with her family to New York City in the early 1950s. Deanna was artistically inclined and loved women’s fashions. Even as a young girl, Deanna had spent hours drawing, designing, and sewing outfits for her dolls; consequently, it was no surprise to her family when she took a job in the fashion industry. It was Deanna’s dream to someday be successful, wealthy, and own her own company. Deanna worked for a few years as an apprentice for various well-known fashion designers, but she grew frustrated because her creativity was being suppressed more and more frequently.
She decided that it was time for her to venture out on her own. During her apprenticeship years, she had built quite a reputation as a designer and had managed to save some money so that she could invest in her own firm. In 1960, with her savings and some borrowed funds, she founded Deanna Perez Fashions (DPF). DPF’s initial target market was the high-quality, high-priced end of the fashion market, and with Deanna’s fresh new ideas the firm was virtually an overnight success. Deanna didn’t let success get to her head; she continued to come up with new fashion ideas and to broaden her market niche.
As more and more women entered the workplace, DPF focused on quality, medium-priced women’s suits and casual wear, which were very fashionable and were well received in the marketplace. From 1960–1980, the firm’s EPS grew at an average rate of 13 percent per year. Since then, earnings growth has slowed. Initially, DPF financed exclusively with debt and internal funds. However, in 1965 the company issued stock and went public. The 1965 issue reduced Deanna’s ownership interest to 80 percent. The company continued to grow, but at a slower rate, as did the entire apparel industry.
Business soared during expansions and slowed during recessions. Also, DPF was always on the lookout for good acquisitions, so its growth also was boosted by a series of acquisitions. Consistent with its market strategy, the company only acquired designer fashion firms that offered name recognition and quality apparel at a medium price. From the firm’s inception, Deanna Perez consistently elected to finance with internal funds until they were exhausted, then with debt, and then by issuing common stock.
To maximize the availability of internal funds, the firm has never declared a cash dividend, nor has it ever declared a stock dividend or had a stock split. Due to the plowback of earnings, the stock has sold for as high as $350 per share. Deanna Perez frequently stated her strong belief that investors prefer low payout stocks because of their tax advantages, and also that stock dividends and stock splits serve no useful purpose—they Copyright © 1994. The Dryden Press. All rights reserved. merely create more pieces of paper but no incremental value for shareholders.
Also, Deanna felt that higher-priced stocks were more attractive to investors because percentage brokerage commissions are lower on higher-priced stocks than on lower-priced shares. To support her position, she frequently cited the example of Berkshire-Hathaway, whose stock price has risen phenomenally, even though in 1995 it sold for over $32,000 per share and paid no dividends. DPF’s rapid growth required a number of stock issues over the years, and when Deanna died in 1985, her family held only about 35 percent of the common stock.
The business was passed on to Deanna’s daughter, Alana, who had inherited her mother’s eye for fashion. Alana was reluctant to see the family ownership diluted any further, so she adopted a policy of financing growth exclusively with internal funds and debt, except that some stock was issued to key employees as part of their compensation packages. To maximize internal funds, Alana continued retaining all earnings, but in spite of this policy, debt rose sharply, and by 1995 the debt ratio was significantly above the industry average, and the Times-interest-earned Ratio had fallen from 4. in 1985 to 1. 5 in 1995. Also, DPF’s liquidity position had deteriorated considerably. See Table 1. The firm has continued to face problems in its target market during the frugal nineties, as have other apparel firms. The money spent on apparel has dwindled for a number of reasons. First, clothing has never been involved in as much competition for the consumer dollar as it now faces. Purchases of constantly updated personal computers and communications equipment is a relatively new element now taking a big chunk of disposable income.
Second, the overriding trend toward casual dressing, the wearing of untailored, easily cared for, and lower-priced clothing cuts down on the number of garments needed by the average household, as well as the dollar outlay per garment. Third, the women’s wear industry hasn’t brought out a strong, overriding fashion statement in several years. In the past, the absolute need to change to long skirts, for example, made most wardrobes completely obsolete after one season. Nowadays, the varying dress lengths allow a woman to carry over most of the items in her closet to another season or more.
Finally, the lack of significant gains in the average person’s real income and the constant publicity about job layoffs seem to have convinced many people to make their old clothing do. For these reasons, consumers in the ‘90s have become quite price conscious, and lower quality clothing brands have become increasingly competitive. Some competing firms in the high-tomedium- priced end of the market have sought growth opportunities in foreign markets, but DPF has remained solely in the domestic market. The net result has been a further decline in growth during the period 1991–1995.
As the date for DPF’s annual stockholders’ meeting approached, Barbara Stark, the corporate secretary, informed Alana that an unusually large percentage of shareholders had not returned their proxies. On the basis of correspondence with stockholders, Barbara felt that the low return percentage might be due to rising discontent over the firm’s dividend policy, plus, of course, its recent lackluster financial performance. Also, Barbara noted that there had been a flurry of stock purchases recently, and that the newly acquired stock was concentrated in street name accounts with Wall Street brokerage firms.
Alana was aware of several reports in the financial press in recent months indicating that DPF was a possible takeover target. Since she and other family members (several of whom were on the payroll) did not want to lose control, they were anxious to keep the outside stockholders as happy as possible. Accordingly, Alana decided, somewhat reluctantly, that the directors should hold a special day-long meeting shortly after the annual meeting to consider possible actions, including a change in dividend policy.
Alana asked David Cooke, DPF’s financial vice-president, to set up the meeting and to lead the discussion. David’s brother, a banker, had recently attended a seminar at which a professor from Columbia University had discussed dividend policy, and he had given David an outline of the talk. David thought about hiring the professor as a consultant, but he knew that Alana disliked academic consultants. Therefore, David asked a new member of his staff—you—to take the professor’s outline and help him apply the various points to DPF. David’s idea, which Alana liked, Case: 19B Dividend Policy as to discuss with the board the pros and cons of alternative dividend policies, and then, with that background, have the board consider what action the company should take. Here are the 10 major points covered on the professor’s outline: 1. Do investors prefer dividends to retained earnings?
2. How should investment opportunities influence dividend policy? 3. What “signals” do companies send investors through dividend actions? 4. How should a firm’s “stockholder clientele” affect its dividend policy? 5. Can dividend policy reduce “agency costs,” and would that increase stock prices? . When establishing its dividend policy, a. how should the target payout ratio be set? b. how stable should dividends be, and what does “stability” mean? c. should the dividend policy be formally announced? 7. If a company’s current policy is inappropriate, how should it make the transition to a new policy? 8. When is repurchasing stock a good alternative to cash dividends? 9. What are the pros and cons of dividend reinvestment plans? 10. What are the pros and cons of stock dividends and stock splits, and how are these actions related to cash dividends?
David Cooke’s brother told him that the professor had illustrated these points with data on Exxon, and that the talk went extremely well. He recommended that David do the same thing with DPF, and David decided to take this advice. So, after assembling the data shown in Tables 2 and 3, David started to work on the project. Now assume that you are David’s assistant. You must work with him to formulate policy recommendations and to present these recommendations to the board. David thinks the best approach would be to systematically march through the professor’s list of points, discussing each point as it applies to DPF.
He also thinks it would be useful to put things into an historical perspective, contrasting, if appropriate, what might have been an appropriate policy for the company in its early years versus what would be an appropriate policy today. Toward the end of the conversation, and in a soft voice, David brought up another point that neither he nor anyone else has the nerve to discuss openly. Alana is now 52 years old, which is not very old, but she is in poor health, and in recent years she has been almost obsessed with the idea of avoiding taxes.
Further, the federal estate tax rate is currently 55 percent, and an additional 10 percent state estate tax would also be due. Therefore, well over half of Alana’s net worth (about $30 million at present) as of the date of her death will have to be paid out in estate taxes. Since estate taxes are based on the value of the estate on the date of death, to minimize her estate’s taxes, Alana might not want the value of the company to be maximized until after her death. David has no intention of bringing this issue up at the meeting, but it clearly bothers him.