Financial Case of Deanna Perez Fashions Inc

Table of Content

1. In comparison to industry standards, the financial strength of Deanna Perez Fashions can be determined by analyzing its Current and TIE ratios. Both of these ratios indicate the company’s ability to cover expenses in relation to the industry. However, DPF’s ratios show that they are not as capable as the industry in this regard. Specifically, DPF’s current ratio, which measures the extent to which short-term creditors’ claims are covered by current assets, is significantly lower than the industry average. This suggests that DPF’s liquidity position is relatively weak. Additionally, DPF’s TIE ratio, which compares their operating income to annual interest costs, is also much lower than the industry average. This indicates that DPF has less flexibility compared to the industry in terms of how much its operating income can decline before it becomes unable to meet its interest costs. Over the years, DPF’s financial performance has been deteriorating. While their Current and TIE ratios were on par with the industry in 1985, they have since weakened. As a result, DPF’s weak financial position is likely to affect their dividend policy as they will be compelled to retain earnings rather than distribute them, in order to safeguard themselves against bankruptcy costs and legal action.

The ongoing debate over investor preferences between dividends and retained earnings remains unresolved. There are three commonly discussed explanations for understanding dividends. Firstly, according to MM, some argue that dividends hold no significance for investors who solely care about total returns (dividends, capital gains or both). Secondly, others suggest that the higher tax rates on dividends compared to capital gains make them less favorable and could lead to lower stock prices for companies paying out dividends. Lastly, dividends may provide insights into a firm’s future earnings potential. Significant increases in dividends can drive up stock prices while dividend cuts can have the opposite effect. Therefore, if investors perceive changes in dividend policies as indicators of a company’s ability and prospects to sustain dividend payments, resulting price fluctuations do not imply a preference for either dividends or capital gains.

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4. The average earnings growth rate over the last 15 years has been 6.9%. It was determined by dividing the EPS of ’95 (14.00) by the EPS of ’80 (6.86), resulting in a ratio of 2.04-1=1.04, and then dividing this ratio by the total number of years (15).
The P/E ratio for DFP during this period has consistently exceeded that of the industry by 1%-5% points, while the M/B ratio has consistently surpassed it by anywhere from 5%-16.5% points.
This indicates consistent improvement in EPS growth at a similar rate as the industry, although not extraordinary.
Shareholders have traded the stock at a premium compared to others in the industry, indicating satisfaction with the current dividend policy.
On average, the stock has yielded an annual return rate of 10.7% over the past 15 years, calculated by dividing 287 by 110 and subtracting 1 to obtain a ratio of 2.609-1=1.609, and then dividing this ratio by the total number of years (15).

DFP’s management should be highly concerned about the signaling theory that may arise if they alter their dividend policy. If the company chooses to decrease their dividend, it could indicate to investors that the company will not be earning enough to sustain a higher dividend payout. This could also suggest to investors that the company has worthwhile projects with positive net present value in progress, which would help reduce the payout ratio. However, it is uncertain how investors will react to this change and it is more likely to have a negative impact rather than a positive one, as indicated by the first viewpoint.

On the other hand, if DFP decides to repurchase its stock, this action could be seen as a favorable signal by investors, suggesting that management believes the stock is undervalued. However, in this scenario, DFP is considered a potential target for acquisition. Therefore, if management buys back shares, it would signify to investors that the company is trying to fend off a takeover bid. Such a signal would be highly negative as it implies that management is not prioritizing maximizing shareholder wealth and working in their best interests.

Due to information asymmetry, stockholders will not have precise knowledge of management’s intentions in all aspects of the business.

6. The importance of the clientele effect in dividend policy cannot be overstated. It is crucial for a firm to be aware of the types of investors who own its stock. If a majority of stockholders are retired individuals in low tax brackets who rely on that income for living expenses, they will prefer a high payout ratio. Conversely, if most shareholders are in their prime earning years, they would rather see the company reinvest the earnings, as they would have to pay ordinary tax income on dividends and then reinvest for capital gains. This emphasizes the need for companies to understand and empathize with their shareholders’ needs, as they are the owners.

7. It is important for DFP to consider agency costs in relation to dividend policy. When there is a lower or nonexistent payout ratio, investors have concerns about how management is utilizing retained earnings. Asymmetric information creates uncertainty about whether the money is being invested in projects with positive NPV or if it is being spent irresponsibly, such as on excessive corporate jets, and so on. These irresponsible actions result in “agency costs”. However, if the company has a higher payout ratio, investors have a clearer understanding of where the earnings are being allocated.

9. It is suggested that considering a stock split or large stock dividend can have positive effects. One advantage is that they can bring the stock price within the optimal range of $20 to $80, allowing for economical round lot purchases with reduced commissions. Moreover, these actions are viewed as a sign of confidence in future success and can be interpreted through the signaling theory. The specific effect of the chosen action depends on the accounting method selected by DPF. However, it is advisable to avoid using small annual stock dividends in the future as they do not generate economic value and result in shareholders bearing administrative costs for distribution.

10. The company may find it beneficial to repurchase its stock instead of giving out a cash dividend, but the choice ultimately relies on our shareholders’ preferences. We need to comprehend whether they would rather receive cash dividends or observe capital gains in order to make the correct decision. Understanding our shareholders is crucial as dividends hold little significance; if no dividends are given, individuals can always sell some of their stock to obtain the required cash.

13. The uncertainty surrounding whether or not DFP should pay dividends is contingent upon the client base of its majority shareholders. If said clients have a low tax bracket, it would be wise for the company to begin distributing dividends to shareholders. These dividends should be sufficient enough to fulfill shareholders’ needs while still being manageable for the firm in times of difficulty. Alternatively, if clients prefer capital gains, DFP may want to consider implementing a stock buyback program in order to increase stockholders’ wealth. Should the decision be made to pay dividends, an official announcement by the company would be necessary. This announcement could have both positive and negative implications: on one hand, shareholders may perceive it positively as they will know how much retained earnings are being spent, alleviating concerns about agency costs; on the other hand, investors may interpret it negatively as a sign that the company lacks profitable projects with a positive net present value (NPV) for overall growth, potentially impacting shareholders’ wealth.

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Financial Case of Deanna Perez Fashions Inc. (2018, Jun 27). Retrieved from

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