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Case 3 FIN500 Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

Dividend Policy at FPL Group, Inc.

Executive Summary Florida Power & Light Company was formed in 1925 through the consolidation of numerous electric and gas companies. After enjoying steady growth until the 1970s, FPL began experiencing operating problems and reduced profitability due to factors like rising fuel costs and construction over-runs. To address these problems, Chairman Marshall McDonald decided to diversify into higher growth businesses and guided FPL to make four major acquisitions- Colonial Penn Life Insurance Company, Telesat Cablevision, CBR Information Group Inc. and Turner Foods Corp. FPL Group also established a real estate development subsidiary called Alandco, and an alternative energy subsidiary called ESI Energy.

To address complaints from consumers, FPL instituted a quality control program inspired from Japanese methodologies. Despite all these moves, FPL continued to face underlying growth problems due to losses at Colonial Penn business, federal concerns over FPLs nuclear reactor safety and going overboard with their quality control program. James Broadhead succeeded McDonald in 1989 and started developing a long range strategic plan for FPL. Broadhead simplified the quality control program. He wanted FPL to focus on its core business and made plans to sell several non-utility businesses that the group held. Broadhead started an aggressive capital expenditure program of $6.6 billion for expansion. To cut costs, Broadhead flattened the organization and eliminated about 4000 positions from 1991 to 1993. Broadheads strategic plans were successful and by 1994 FPL became the largest utility in Florida and the fourth largest in the country. FPLs sales growth exceeded the national average and this trend was expected to continue over the next five years. California proposal on retail

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi


wheeling had a large impact on the electric utilities industry. Following California, utility commissions of 23 other states were considering retail wheeling proposals. If and when Florida regulators authorized retail wheeling, FPL would have many potential competitors. Based on these major events, S&P revised the ratings of FPL. Merrill Lynch utilities analyst was downgrading FPL Group due to the expectation that the FPL Directors will not choose to raise the annual dividend and were considering reviewing their dividend policy. FPL Management believed that the dividend payout ratio was high given the risks facing the industry. Kate Stark, the electric utilities analyst at First Equity Securities Corporation, was contemplating how to revise her recommendation for FPL given the recent 6% drop in share price and proposed change in dividend policy.

1. Why do firms pay dividends? What, in general, are the advantages and disadvantages of paying cash dividends? Taking into account the many theories of dividend policy including the Dividend Irrelevance Theorem, the Information Effect, The Clientele Effect and Corporate Control Issues, firms should pay out as dividends any cash flow that is surplus after the firm has invested in all available positive net present value projects.i In some cases, this may be a way of showing that the company is financially stable and capable of fulfilling dividend obligations. It may also be a way for companies to mitigate agency problems when they have excess cash.

Advantages of paying cash dividends include: A signal of the value and stability of the business A means of distributing excess cash The tendency to increase stock prices when announced

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi


A way of keeping managers in check and mitigating agency problems when high retained earnings dont max out shareholders value

Higher proportion of pension funds/ tax exempt institutions are the shareholders

Disadvantages of paying cash dividends include: Taxation at a higher rate than capital gains Limits on the growth the company if dividends are paid instead of completing a positive NPV project. Once established they are difficult to eliminate and doing so will often affect the price of the stock They have no impact on the value of a company and the stockholders can create dividends by simply selling the stock

2. Suppose FPL will pay an annual dividend of $2.48 in 1994, and assume the market risk premium (RM Rf) is 7.5% and the risk free interest rate is 7.3% (the current yield on 30-year Tbonds from Exhibit 8), and FPL Group Inc. stock is selling at $34 per share, what is the expected capital gains yield of FPL stock?

Expected capital gains yield = expected rate of return - dividend yield

Expected rate of return = i = Rf + (RM - Rf) = 0.60 (RM - Rf) = 7.5% Rf = 7.3%

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi i = Rf + (RM - Rf) = 7.3% + 0.60 * 7.5% = 7.3% + 4.5%= 11.8%


Dividend yield = dividend/ price = $2.48/$34.00 = 0.073 = 7.3%

Expected capital gains yield = expected rate of return - dividend yield = 11.8% - 7.3% = 4.5%

3. From FPLs perspective, is the current payout ratio appropriate? Would a higher or lower payout ratio more appropriate? Explain and justify your answer based on information in the case. From FLP group perspective the current payout is too high based on the information provided in the case. It was provided that the company was paying out in the range 90% of its earning. The company will be better off saving those extra earnings for the purpose of reinvestment, future expansion, or unforeseen future competition. Another area of future concern for FPL is retail wheeling, which has a chance of being adopted by Florida, especially since it can potentially cut into their future earning, it will allow customers to be able to buy energy from other suppliers other than the monopoly supplier. So it would be in there best interest to maintain a high reserve in order to protect themselves from future vulnerability. 4. From an investors perspective, is the FPLs payout ratio appropriate? Explain and justify your

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi answer based on information in the case.


According to the case, the payout by FPL is appropriate. The case further emphasized that investors are used to getting high payouts from the utility companies. Looking at the case, it was reported that after FPL announced the change in dividend policy on March 3rd, 1994, that it would be difficult to increase the dividend. Then on May 9th, 1994 FPL announced the dividend cut with the stock repurchase program and the stock price fell $43.75 to $27.50. Then on May 31st, FPL's stock closed at $32.17, or about 30 cents higher than the pre-announcement price. One year later, FPL's stock price closed at $37.75, giving stockholders a return of 23.8%. Finally, almost two years later on April 1, 1996 FPL's stock was trading at $45.25, which provided stockholders with a post-announcement return of 52.9%. Investors ran for cover because they were not used to this type of announcement for this sector, so such news is considered as being negative news, especially for a company that has steadily increased dividends payout for the past 48yrs. On the other hand once investors see that FPL was repurchasing its stocks, this gave them the information that the stocks are healthy and will be increasing in the near future or else why would they be repurchasing if FPL is not stable.

It's also possible that this was a strategic move on FPL's part to cut dividend which brought the stock's price down, and then repurchase the stocks which gives investors that are waiting on the fence the confidence to jump in and buy the company's stocks, whereas in actuality the company is undergoing financial trouble.

5. As Kate Stark, what would you recommend regarding investment in FPLs stock buy, sell, or hold?

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi


A recommendation from Kate Stark would be based on the what-ifs in the following weeks on the fence between the original recommendation to hold, and the possibility of future outcomes leaning towards buying. As Merrill Lynch had stated in their report in the beginning of the article, FPL seems to have no intention to raise the annual dividend above $2.48. Coupled with the fact that FPLs management recognizes the fact that their dividend payout levels are high (though consistent with the industry average), it makes mention of two ways to address the high payout levels: to grow out of a high payout, and to cut dividends. Though Merrill Lynch ended by saying that they were expecting the dividends to remain, their assumption would be based on the historical fact that FPL has had a 47 year streak of returning an increase in dividends, and the company would be unlikely to differ. However, the bigger, more profitable picture must be looked at, rather than the immediate.

A Hold recommendation would be suitable only in the circumstances that FPL makes no moves in regards to dividends, and that the uncertainty surrounding the company and its industry remains murky.

However, FPL should be considering its possibility of profitability long into the future, and the company already recognizes one main factor which is holding it back: dividends. For future growth, it would be best that the company cut dividends by the theorized 30%. By doing this, share prices would drop as the market would react negatively in regards to the reduction, allowing the company to repurchase a substantial amount of their outstanding shares at lower prices. Following this, the proposed savings of over $150 million every year would allow for FPL to repay its debt, giving it greater financial flexibility, and allowing for more free cash flow. The foreshadowing of this possibility would be the 6% drop in FPL granted it cannot be confirmed if this is in reaction to the new reports, this could be the precursor to future events. If things were to follow as such, FPL would be able to grow at faster rates than ever

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi


before, recovering its dividends by 1998 and therefore making their investors more profitable in the end. This, if it were the case, would warrant a Buy recommendation.

Despite this, the previously stated possibilities are just that possibilities. Since nothing has been confirmed, neither in the affirmative of dividend cuts nor growing out of a high payout, it would be rash for Stark to recommend anything but Hold. Since FPL remains at a stable financial position, and Stark still believes that FPL will retain their dividends at $2.48, there is no reason for anything but a Hold recommendation until there are confirmed reports of dividends being cut.

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Cornett, Marcia, Adair, Troy, and Nofsinger, John. Finance: Theory and Applications. 2009: United States. McGraw-Hill Irwin. p. 495.