Dividend Policy: FPL Group, Inc.

Background:
Florida Power and Light Company (FP&L), the major subsidiary in FPL Group, is an electric
utilities company in an industry of increasing deregulation since the 1970s. FP&L was formed in
1925 through a consolidation of several gas and electric companies. During the 1970s rising fuel
cost, construction cost overruns and FP&L operating problems reduced the companies growth and
profitability. Marshall McDonald, FPLs then chairman, in an effort to increase profitability
underwent a period of diversification and expansion in the 1970s and 80s, acquiring major
companies in various industries, such as cable television, insurance, real estate, and information
services. The company solved their operational problems in the late 1980s but was now faced with
an increasing demand for electricity alongside a growing prospect of competition in 1989.
Following Marshall McDonalds retirement in 1989, James Broadhead, his successor,
streamlined the companys business operations. At FPL, Broadhead implemented a commitment to
quality and customer service, increased its focus on the utilities industry, expanded capacity, and
improved its cost position. In the 1990s, Broadhead sold off several of FPLs non-utilities
businesses. Chairman James Broadheads vision for the electric utilities business was one of free and
open competition, and he intended to better position FPL for such a marketplace.
In May 1994, Merrill Lynchs utilities analyst lowered their investment rating for the FPL
Group. The analyst downgraded FPL because they believed FPL was on the verge of cutting its
dividend for the first time in 47 years. Kate Stark, an electric utilities analyst at First Equity
Securities Corporation, after hearing the news, was faced with the decision whether or not to revise
her own current hold recommendation on FPLs stock.
Issue:
Given the current situation should FLP raise, lower, or leave its dividend flat.

Analysis:
Signal Theory
One factor to consider in deciding to raise, lower or hold dividend levels is whether or not
signaling exists in the market. If we assume signaling exist then any increases in dividend, even
minimally, will signal to stockholders that the company insiders are confident in the continued
strength of FPL. The company has just completed a five year capital expenditure program to increase
the production capacity to meet future demand. This has led to a fall in the cost per kilowatt hour
from $1.82 to $1.61. Also, over the coming five years, capital expenditure is projected to drop 33%.
During this time period, sales growth is projected to be higher than the national average.
There is only a small increase in the dividend to signal the companies caution due to the unknown
impact of retail wheeling. This issue is not on the table in Florida at this time, but 23 states are
considering it. It may only be a matter of time before Florida moves in this direction. There is also
caution due to the increased debt rating by S&P.
Clientele Effect
The decision to increase the dividend is partially based on the clientele of FPL stock. It is fair
to assume that the bulk of the investors are primarily interested in dividend growth rather than stock
price appreciation since FPL is a utility. The stock price for FPL does not stand out from the pack, but
the payout ratio is high for the industry. The investor base which is 51% individuals and 18% pension
funds/universities has primarily been rewarded for their investment through dividends. In fact, for 47
years straight, there has been a dividend increase, and making it 48 will continue the incentive to
invest in FPL. Any deviation from increasing the dividends might cause a negative reaction by
investors.
Return on Invested Capital Vs WACC

Another factor to consider when deciding whether dividends should increase, decrease or
remain the same is whether or not the companys return on invested capital (ROIC) is greater than the
weighted average cost of capital (WACC). If FPL were to find that the ROIC during 1993 was less
than the companys WACC, they would probably want to continue issuing dividends. ROIC is
calculated by dividing the after-tax earnings before interest by the sum of the companys equity and
interest bearing debt. In FPLs case, they have two types of interest bearing debt: long-term debt,
including bonds, and commercial paper, a form of short-term debt. For 1993, with EBIT of
$1,046,008, a tax rate of 37%, and combined debt and equity of $9,027,120, the companys ROIC
was 7.3% (Exhibit A). The calculation of FPLs WACC presents more challenges than the
calculation of ROIC (Exhibit B). Because the companys current interest rate is not known, the cost
of debt must be calculated using the companys average cost of debt. Likewise, because the number
of outstanding shares of preferred stock and their market value are not known, the cost of preferred
stock and its weight in the capital structure must be based on book values. The cost of equity can be
calculated using both the capital asset pricing model (CAPM) and the dividend discount model.
Using that periods risk-free rate of 4.19% and the companys current beta of 0.60, a cost of equity of
9.0% can be calculated. Because this is barely higher than the cost of debt, it should not be used.
Using the dividend discount model based on a two cent increase in the dividend, a market price of
$32, and a growth rate of 3.8% based on dividends from 1984-1993, the companys cost of equity is
11.6%. Using these costs of financing and the companys capital structure, a WACC of 9.0% can be
calculated (Exhibit C). With a ROIC of 7.3% and a WACC of 9.0%, the company essentially
generates less return on the capital it has received than it would cost the company to obtain further
capital. Considering the companys low beta, implying relatively low returns and low risk, this is not
surprising. Because the ROIC is less than the WACC, it would be better to return the companys

earnings to its shareholders in the form of dividends than it would be to retain those earnings within
the company.
Investment Opportunities
Dividend policy holds that when a firm has potential opportunities to reinvest back into the
company, the firm should do so and hold off on raising dividends. Thus, when opportunities are not
present dividends should continue to be paid. When James Broadheads stepped in, his vision for
FLP was to focus on the firms core competencies. In doing so the diversification programs of FLP
would be cut back. Also, an aggressive capital expenditure program of $6.6 billion was implemented
to meet projected demand into the next decade. This expansion included building a new transmission
line, refurbishing the oldest generating plant, and improving operating efficiency at all plants. These
efforts put FLP in a great position by 1994 in terms of operating efficiency and plant availability.
This is promising even with the increased competition that will result from retail wheeling.
Cash Flow
Looking at projected cash flows, FLP expected annualized sales growth over the next five
years (1994-1998) of 2.7%. Also, capital expenditures starting in 1994 were expected to decline by
33% over the next five years. So even in the environment of increased competition, FLP will see an
increase in cash flow. Because of this promising outlook, FLP is able to increase dividends slightly.
Steady/Predictable and Life Cycle
Regarding the stability and predictability of the utility industry, Broadhead developed a longrange strategic plan for an industry he saw as having full and open competition. He had already
worked in the telephone business which had been deregulated. After speculating about the industrys
future in terms of technological requirements, regulation, and customer needs, it was concluded that
FPL needed to commit to quality and customer service, increase their focus on the utilities industry,
expand capacity, and improve cost position. The future in the electric utility industry was somewhat

hazy due to the proposals of retail wheeling. If this was to be passed in Florida, FPL would face
more competition. Even with FPLs high dividend payout ratio comparatively to the industry, the
industry was known for high payout ratios. FPL had gone through a 47 year streak of dividend
increases and breaking may cause negative investor reactions. There should be a constant flow of
dividends and cutting the dividend is not common except in situations of financial trouble and FPL
do not have financial problems. As long as FPLs earnings increase at a faster rate than dividends,
the payout ratio would slowly decrease as this is what we plan to do by issuing an increase in
dividends at a lesser growth rate than previous years. This will also bring us to par with the rest of
the industry in the not to distant future.
The life cycle consists of four stages: development, growth, maturity, and decline. FPL was
founded in 1925 and is currently in the maturity stage. In the maturity stage, it is best to pay bigger
dividends to reward investors, and this is what we are going to do as opposed to cutting or keeping
the dividend rate the same.
Recommendations/Conclusions:
After our analysis it is our recommendation that FPL increase its dividend payment to 2.49
per share. Our recommendation assumes that signaling exists in the market and that this 2 cent
increase in dividends will convey the message that the company plans on maintaining and surpassing
income levels in the future. Also FPLs investors, like most utility companies have investors that are
more focused on a steady source of income rather than stock growth. If we were to cut dividends our
investors might trade in their shares for other dividend stocks which might depress the stock price.
Although we are recommending an increase in dividends we realize that the deregulation of the
industry brings new competition to the market. To cope with this increase competition we have
recommended only a small increase of 2 cents as opposed to and average of 5 cents increase over the
last 5 years. We would use the extra money saved to increase capacity and also to aggressively pay

down dept thus increasing flexibility. Finally it is our belief that by cutting back slightly in the
amount of increase in dividends and using the excess funds to increase capacity and flexibility the
company would eventually grow out its high dividend payout ratio of 90%.