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Background:
Established in 1886, Avon was one of the worlds largest manufacturers and marketers of
beauty products. Avons was famous for its direct sales beauty business, which was also the
key source of their revenues. In 1988, Avon had about 1.4 million active sales representatives
worldwide.
Apart from the beauty sector, Avons other principal business group was its Health Care
Group, which comprised Foster Medical Corporation, the Mediplex Group, and Retirement
Inns of America. Due to optimistic future returns in the Health Care Group, Avon continued
their investments in this sector. Thus Avon took the strategic decision to acquire Mallinckrodt
Inc. $710 million in 1982, Foster Medical Company in a share exchange in 1984, Retirement
Inns of America in 1985 and the Mediplex Group in 1986.
From the above data, we observe that even though the sales in 1986 were about 1.5 times the
sales in 1985, the pre-tax earnings increased only marginally, showing the expenses of the
segment had gone too high.
By 1987, the performance of Beauty Group had improved considerably which is why Avon
decided to focus on this segment and exit the Health Care Group. Avon began the process of
selling the Foster Medical Corporation anticipating an after tax loss of $125 million. Also
they sold Mallinckrodt Inc. suffering a loss of approximately $35 million. Also, Avon
acquired various perfume producers in 1987 which helped in their transition from direct sales
approach to retail outlet approach along with diversification of product line. Avon raised
capital by selling 40% of common stock in Japan subsidiary for an after tax gain of $121.1
million. These actions implied that Avon would continue to invest significant capital in the
business. The board thus suggested that Avon should conserve cash flow by reducing
dividends.
1987:
The board suggested that Avon should conserve cash flow by reducing its dividend to $1 per
share, but Mr. Waldron worries that simply cutting the dividend would lead to a steep drop in
the stock prices because some investors had stated that they held Avon stock because it paid a
high dividend. Also, the largest institutional investor for Avon, Delaware Management Co.s
primary investment objective is Yield of the share (Exhibit 5). Hence, simply cutting the
dividend can lead to drastic consequences this time.
The three scenarios listed here gives a picture for the potential revenue distribution for Avon
Products:
1) Scenario 1: About 25.25% shareholders would be interested in PERCS as
per the Exhibit 5 since they can obtain an assured gain of $5.87/share for
this exchange. Also this would retain about $53.4 Million in earnings with
dividends averaging $1.25/share. (Our Proposal is to go for this,
taking positive action on all the three options on the case)
2) Scenario 2: About $143.4 Millions would be required for keeping
shareholders content.
3) Scenario 3: About $71.7 Millions would be retained as earnings to be
reinvested in the company however, this would result in a falling of price
from ~$24 to ~$12/share.
Notes Amount
Current Price of Common Stock $ 24.13
Dividend Discount for PERCS
Year
1988 Q3 (Now) $ 30.13
1988 Q4 $ 0.50
1989 Q1 $ 0.50
1989 Q2 $ 0.50
1989 Q3 $ 0.50
1989 Q4 $ 0.50
1990 Q1 $ 0.50
1990 Q2 $ 0.50
1990 Q3 $ 0.50
1990 Q4 $ 0.50
1991 Q1 $ 0.50
1991 Q2 $ 0.50
1991 Q3 $ 32.00
Benefit/Share to the shareholders opting for PERCS $ 6.00
Stock prices for $2 Dividend $ 24.39
Stock prices for $1 Dividend $ 12.20
Assumed Dividend Growth 5%
US Treasury Notes 8.20%
Price if Current Dividend (@$2) $ 65.63
Price if Current Dividend (@$1) $ 32.81