Dividend policy at FPL Group, Inc.

Govert Wessels & Emily Degraeve

1. Why do firms pay dividend? What, in general, are the advantages and
disadvantages of paying cash dividends?
Dividend refers to a portion of the net income of a firm that is distributed to
the owners/shareholders of that firm. Enterprises pay dividends when their
earnings exceed their investment possibilities. Furthermore, the payment of
dividends might be a sign of company strength and confidence of the
management in its ability to generate future profits.
There are several advantages of paying dividends. First of all, as mentioned
before, it is a sign of company strength and profitability which might
positively influence stock price and attractiveness. This implies that the
announcement of increased dividends might have a positive impact on stock
price. Furthermore, when a company steadily pays dividends, it becomes
attractive to investors that are looking for a source of fixed-income. Another
possible advantage would be that dividends are a good way of dealing with
an excess of cash held by the firm, therefore reducing the chance that this
money would be used for negative NPV projects.
On the other hand, there are also a number of disadvantages. In theory, all
investors have the ability to create homemade dividends by selling their
shares at any given point in time, which would mean that the decision to pay
dividends should not influence stock price. Furthermore, a firm is first
required to pay corporate taxes over its generated income, resulting in the
net income where dividends are paid from. However, when an investor
receives dividends, he/she is required to pay income taxes on this dividend as
well. Besides that, the payment of dividends results in a cash outflow, leading
to less cash available to invest in positive NPV projects. Lastly, when a firm is
committed to a certain dividend policy, a deviation from this policy (a
decrease of dividends) will most likely negatively impact the stock price.
2. What are the most important issues confronting the FPL Group in May
1994?
One of the issues confronting the FPL group at that time were the
negotiations of a settlement between FPL and the FMPA. Furthermore, their
rating as an investment went down as the company was struggling to meet
up to the expectations of continuing to raise dividends. One of the possible

solutions for this problem was to simply cut dividends as suggested by

managers.
Because of changes in regulations on retail wheeling, the landscape of the
sector became more competitive. As a result of this change, S&P announced
that they would start to use different evaluation guidelines within this sector.
These new guidelines initially resulted in a better rating of FPL, placing them
amongst the top 10% of investor-owned utility companies. However, because
of increasing interest rates and the increase in competition, FPLs stock price
took a hit and went down by 19.6% while the Industry Index went down by
22.1%. This is a relative poor performance, given their beta of 0.60.
Because FPL has a relatively large amount of debt, the rising interest rates
put a pressure on the companys ability to pay the promised dividends. Also,
despite of their efforts to control the quality of their business, their nuclear
plant was put on a watch list because of safety concerns. Furthermore,
demand was growing exponentially and was projected to exceed the capacity
in the near future. Another issue was that some of the non-utilities
subsidiaries lost a lot of money and lastly, employee morale showed to be
very low because of the pressure that the quality management program
created.
3. From FPLs perspective, is the current pay out ratio appropriate? Would
a higher pay out ratio be more appropriate? A lower pay out ratio?
In exhibit 7 is visible that FPLs current payout ratio is 91% when considering
all forms of dividend. Judging by the information available, this payout ratio is
too high considering the increasing interest rates which put a pressure on the
companys ability to pay the interest on its debt. Furthermore, the threat of
increased deregulation leading to retail wheeling would hamstring FPL in its
ability to maintain this high payout ratio. Besides that, when comparing FPLs
payout policy to the rest of the Investor-Owned utility companies, the
average payout ratio is only 75%, whereas FPL pays 91%. This might result in
FPL having a hard time staying a head of the competition as it is limited in its
investment possibilities due to limited availability of cash.
4. From an investor perspective, is FPLs pay out ratio appropriate?
From the standpoint of institutional investors, which hold 36.9% of FPLs
common stock following from exhibit 10, the payout ratio might be attractive
as the current US tax regime exempt dividend income from taxation for

institution. Hence, to maximize their return they would prefer dividends over
capital gain.
From the standpoint of individual investors, which hold 51.9% of FPLs
common stock, it should not matter what the payout ratio is, as they have
the ability to create homemade dividend to shift their profit towards capital
gain away from dividends, which is advantageous to them because it would
allow them to avoid the double taxation described earlier.

5. As Kate Stark, what would you recommend regarding investment in

FPLs stock? Buy, sell or hold?
Initially, Kate Stark gave a hold recommendation for the stock. This
recommendation was based on the thought that dividends would remain
constant or grow slightly from $2.48 (per share). FPLs management has
declared that the current dividend policy is deemed excessive, but
provided two possible solutions: they could either outgrow the high payout
rate or cut dividends and have not shown bias towards either of the
solutions. As FPL expects to experience strong growth in the future
(exhibit 6), it does not seem unreasonable to think that FPL might manage
to outgrow their high payout ratio. However, the increase of interest rates
and the possibility of introduction of retail wheeling in Florida might pose a
threat to FPLs future performance. We think that a further increase of
interest rates would not change the recommendation, as the stock already
declined 19.6% over the past nine months, and we deem it unlikely that it
would decline any further. With regards to the possibility of retail wheeling,
there seems to be no reason to think that FPLs has greater exposure than
any other investor-owned utilities company and therefore it seems not
unreasonable to think that FPL will be able to live up to the expectations of
continuing to pay $2.48 dividends per share.