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Case 63

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Deanna Perez Fashions, Inc.

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Dividend Policy

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As a young adult in her mid-twenties, Deanna Perez emigrated from Spain with her family to New
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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; con-
sequently, it was no surprise to her family when she took a job in the fashion industry. It was
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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
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decided that it was time for her to venture out on her own. During her apprenticeship years, she had
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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).
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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
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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
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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 per-
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cent. The company continued to grow, but at a slower rate, as did the entire apparel industry. Busi-
ness 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 mar-
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ket strategy, the company only acquired designer fashion firms that offered name recognition and qual-
ity 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 availabil-
ity of internal funds, the firm has never declared a cash dividend, nor has it ever declared a stock div-
idend 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
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of their tax advantages, and also that stock dividends and stock splits serve no useful purpose—they
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Copyright © 1994. The Dryden Press. All rights reserved.

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merely create more pieces of paper but no incremental value for shareholders. Also, Deanna felt that

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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 fre-
quently cited the example of Berkshire-Hathaway, whose stock price has risen phenomenally, even

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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

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to Deanna’s daughter, Alana, who had inherited her mother’s eye for fashion. Alana was reluctant to

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see the family ownership diluted any further, so she adopted a policy of financing growth exclusively

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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

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spite of this policy, debt rose sharply, and by 1995 the debt ratio was significantly above the indus-

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try average, and the Times-interest-earned Ratio had fallen from 4.2 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

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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
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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 sev-
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eral 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
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in the average person’s real income and the constant publicity about job layoffs seem to have con-
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vinced many people to make their old clothing do.

For these reasons, consumers in the ‘90s have become quite price conscious, and lower qual-
ity clothing brands have become increasingly competitive. Some competing firms in the high-to-
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medium-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.
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As the date for DPF’s annual stockholders’ meeting approached, Barbara Stark, the corpo-
rate 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
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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 pur-
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chases 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
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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, includ-
ing 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
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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 pro-
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fessor’s outline and help him apply the various points to DPF. David’s idea, which Alana liked,
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was to discuss with the board the pros and cons of alternative dividend policies, and then, with that

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background, have the board consider what action the company should take. Here are the 10 major
points covered on the professor’s outline:

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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?

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4. How should a firm’s “stockholder clientele” affect its dividend policy?

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5. Can dividend policy reduce “agency costs,” and would that increase stock prices?
6. When establishing its dividend policy,

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a. how should the target payout ratio be set?

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b. how stable should dividends be, and what does “stability” mean?
c. should the dividend policy be formally announced?

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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?
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10. What are the pros and cons of stock dividends and stock splits, and how are these actions
related to cash dividends?
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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,
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David started to work on the project.

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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
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point as it applies to DPF. He also thinks it would be useful to put things into an historical perspec-
tive, 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.
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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
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of avoiding taxes. Further, the federal estate tax rate is currently 55 percent, and an additional 10 per-
cent state estate tax would also be due. Therefore, well over half of Alana’s net worth (about $30
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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 inten-
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tion of bringing this issue up at the meeting, but it clearly bothers him.
To help you and David prepare for the board meeting, answer the following questions.

QUESTIONS
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1. On the basis of the data in Table 1, what can you say about DPF’s financial strength relative
to the average firm in its industry? Has DPF been getting stronger or weaker in recent years?
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What effect is its financial strength likely to have on DPF’s dividend policy?
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2. Do you agree with Alana Perez that investors generally prefer to have companies retain

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earnings in the business to generate growth and capital gains rather than distribute earnings
as dividends?

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3. Does DPF’s dividend policy seem to have been consistent with its investment opportunities
across time? To obtain an indication of the company’s average investment opportunities,
determine approximate ROE’s by dividing EPS by Book Value per share. As a part of your

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answer, construct a graph that can be used to show the general relationship between a firm’s

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cost of capital, changing investment opportunities, and the impact on the size of its capital

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budget. Explain how this would affect the company’s optimal dividend policy. Show dollars
on the horizontal axis and percent on the vertical axis.

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4. Based on growth in earnings, the P/E ratios, and the Market/Book ratios, do investors appear
to approve of DPF’s dividend policy?

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5. Should DPF be concerned about signaling effects if it plans to alter its dividend policy? If
so, how should signaling be taken into account?

6. In general, and in this case, what impact should “clientele effects” have on its dividend policy?
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7. Should DPF be concerned about “agency costs” when it considers its dividend policy? If so,
how should signaling be taken into account?
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8. Considering DPF’s present financial condition, do you think the company is a likely target
of a hostile takeover attempt? What effect would the firm’s dividend policy have on its vul-
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nerability to a takeover? How might the company use a restructuring that involved asset
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sales to reduce the threat of a takeover?

9. Would you recommend that DPF split its stock, or pay a large stock dividend? Also, should
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it use small annual stock dividends in the future?

10. Would you recommend that the company repurchase stock as an alternative to cash divi-
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dends, if it decides to remit cash to its stockholders?

11. If the company does decide to start paying cash dividends, should they also offer a dividend
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reinvestment plan?
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12. How should you deal with Alana’s estate tax situation? Should you bring it up? If so, in
what context and with what recommendation? If Alana does indeed want to hold down the
stock price (but not hurt the long-run value of the corporation), should the other directors go
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along with her? How would “the market” be likely to deal with the situation, assuming that
they have no information whatever regarding what is said or not said about it within the
company?

13. What are your final recommendations with regard to DPF’s dividend policy? Should the
company begin paying cash dividends, and if so, about how large should the initial dividend
be? Also, should the company’s dividend policy be officially announced, and if so, what
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message should they seek to get out in the announcement?

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TABLE 1

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Deanna Perez Fashions, Inc.
Condensed Balance Sheet for the Years Ended December 31

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(In Millions of Dollars)

1995 1985

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Cash and marketable securities $ 8.2 $ 5.4

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Accounts receivable 376.0 202.6
Inventories 416.4 218.8
Total current assets $ 800.6 $426.8

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Fixed assets 1,889.8 464.9
Total assets $2,690.4 $891.7

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Accounts payable $ 171.4 $ 57.1
Notes payable 401.9 40.6
Other current liabilities 49.7 11.6
Total current liabilities
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Long-term debt $ 725.0 $205.5

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Common stock (1995: 5,000,500 sh) 60.0 59.7
Retained earnings 1,282.4 517.2
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Total common equity 1,342.4 576.9

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Total liabilities and net worth $2,690.4 $891.7

Industry ratios:
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Current ratio 2.4× 2.7×

Debt ratio 38.9% 29.4%

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Times Interest Earned 3.5× 4.4×

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Dividend Payout Ratio 27.5% 22.0%

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TABLE 2

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Deanna Perez Fashions, Inc.
Selected Company Data

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Earnings Book Value Price Industry Industry
Year per Share per Share per Share P/E Ratio M/B Ratio

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1960 $ 0.50 $ 3.33 $ 6.75 12.7× 1.4×

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1970 2.02 13.93 29.75 14.0 1.7
1980 6.86 52.80 110.00 15.5 2.5

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1985 11.50 115.40 218.50 17.5 3.5

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1990 14.68 184.00 315.62 15.2 3.2
1995 14.00 268.45 287.00 15.6 2.5

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Industry Average Compound Annual Growth Rate in Earnings per Share:a

1980–85 11%
1985–90 9
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a
As an approximation, the EPS growth rate can be found as g = br, where b = fraction of earnings retained and r = ROE =
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rate of return on equity. If g and b are known, then we can solve for ROE = g / b to find the average rate of return the com-
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pany has been earning on its equity. If a company’s average ROE over a long period has been low, this probably means
that the company has been investing in projects with low rates of return and low NPVs.
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TABLE 3
Selected Stock Market Data of Selected Firms in Apparel Industry
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Average Payout Average P/E

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During 1991–1996 During 1991–1995

Garan, Inc. 67% 11.2×
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Jones Apparel Group, Inc.* 0 15.5

Kellwood Co. 40 14.1
Liz Claiborne, Inc. 24 16.7
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Oxford Industries, Inc. 50 13.6

*The Company’s initial public offering was May 1991.

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