Case3Team4 v4

Case 3FIN500

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 FPL’s 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. Broadhead’s strategic plans were successful and by 1994 FPL became the

largest utility in Florida and the fourth largest in the country. FPL’s 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 FIN500Team 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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A way of keeping managers in check and mitigating agency problems when high retained earnings

don’t 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 T-

bonds 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 + β (RM - Rf)

β = 0.60

(RM - Rf) = 7.5%

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

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Rf = 7.3%

i = Rf + β (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 FPL’s 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.

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4. From an investor’s perspective, is the FPL’s payout ratio appropriate? Explain and justify your

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.

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5. As Kate Stark, what would you recommend regarding investment in FPL’s stock – buy, sell, or

hold?

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 FPL’s

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

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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

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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