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Executive Summary

In May 1994, FPL Group Inc., a major electric provider in Florida, received an alert from Merrill Lynch,
indicating its investment downgrading. Merrill Lynchs analyst believed that FPL was on the verge of cutting its
dividend for the first time in 47 years. However, only 3 weeks earlier, FPLs electric utilities analyst, Kate Stark, issued
a report on FPL Group with a hold recommendation based on the assumption that FPL would keep its dividend at a
$2.48 per share or increase it slightly.

Several major events had taken place over the past year which had a large impact on electric utilities industry.
Foremost among them was the California proposal on retail wheeling. Because of the changing competitive landscape,
Standard & Poors Rating Group announced a revision of its guidelines for evaluating investor-owned electric utilities
in October 1993.

One of the most important issue of FPL is to decide whether or not to decrease their dividend payout ratio as a
result of an evolving competitive market place.
1. Why do firms pay dividend? What, in general, are the advantages and disadvantages of paying cash

Dividend is a cash distribution of companys earnings. Paying a cash dividend reduces companys cash and
retained earnings. Dividend may be also paid out in shares of stock (stock dividend). This one increases the number of
shares outstanding, therefore reducing the value of each share. The decision to pay a dividend is made by the board of
directors of the company and is distributable to shareholders. Many individuals desire a steady income stream they are
likely to bid up the stock price if dividends rise and bid down the stock price in case of dividends payout ratio decrease.
A) Dividends are paid because it shows that the company is financially strong

Generally, firms pay dividends because investors perceive dividend payments as a sign of the firms strength
and a sign that the management is expecting positive future earnings. It is an effective way to communicate the financial
well-being of the company. Companies who pay dividends are usually companies that are financially strong because its
value stems from its ability to generate and payout its distributable cash flow. A companys willingness and ability to
pay steady dividends overtime - and its power to increase them - provide good clues about its fundamentals. Specially,
the idea is put forth that the value of a share of a stock should be equal to the present value of its future expected
dividend payouts.

Typically, profitable companies pay dividends. However, this does not imply that companies that do not pay
dividends are not profitable. A company can do a lot of things with its profits. If a company thinks that its own growth
opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the
profits and reinvest them into the business. For these reasons, few growth companies pay dividends. In some
companies, much of their profits are distributed as dividends, but they still need to retain a certain amount to fund
certain business activities.
B) Dividends are paid to attract investors

The companies that offer dividends are often companies that have progressed beyond the growth phase. When
companies are no longer able to benefit significantly by reinvesting their profits, they usually choose to pay them out to
the shareholders. Thus regular dividends payouts make holding the stock more appealing to investors, a move the
company hopes will increase demand for the stock and therefore increase the stock's price. Through a distribution from
their earnings, companies indicate a positive future and a strong performance. Few shareholders may also prefer the
certainty of dividends in comparison to the possibility of higher capital gains in future.

If a dividend-paying company is unable to pay dividends for a certain period of time, it may result in loss of
investors who preferred regular dividends and may sell-off the stock in short term.

C) Advantages
Paying dividends to investors has several advantages, both to the investors and the company:
a) Investor Preference for Dividends: The investors are more interested in a company that pays stable
dividends. This assures them of a reliable source of earnings, even if the market price of the share dips.
b) Bird-in-hand Fallacy: This theory states that the shareholders prefer the certainty of dividends in comparison
to the possibility of higher capital gains in future.
c) Stability: Investors prefer companies that have a track record of paying dividends as it reflects positively on
its stability. This indicates predictable earnings to investors and thus, makes the company a good investment.
d) Benefits without Selling: Investors invested in dividend-paying stocks do not have to sell their shares to
participate in the growth of the stock. They reap the monetary benefits without selling the stock.
e) Temporary Excess Cash: A mature company may not have attractive venues to reinvest the cash or may have
fewer expenses related to R&D and expansion. In such a scenario, investors prefer that a company
distributes the excess cash so that they can reinvest the money for higher returns.
f) Information Signalling: When a company announces the dividend payments, it gives a strong signal about
the future prospects of the company. Companies can also take advantage of the additional publicity they get
during this time.
D) Disadvantages
a) Clientele Effect: If a dividend-paying company is unable to pay dividends for a certain period of time, it
may result in loss of old clientele who preferred regular dividends. These investors may sell-off the stock in
short term.
b) Decreased Retained Earnings: When a company pays dividends, it decreases its retained earnings. Debt
obligations and unexpected expenses can rise if the company does not have enough cash.
c) Limits Companys Growth: Paying dividends results in reduction of usable cash which may limit the
companys growth. The company will have less money to invest in the business growth.
d) Logistics: The payment of dividends requires lot of record-keeping at the companys end. The company has
to ensure that the right owner of the share receives the dividend.
2. What are the most important issues confronting the FPL Group in May 1994?

The primary issues confronting FPL Group are: Industry deregulation and retail wheeling, rising interest rates,
and decrease in share price.
a) Industry deregulation and retail wheeling

During the 1970s and 1980s, deregulation eliminated or weakened the monopoly service rights and fixed price
systems common in such industries as trucking, airlines, banking, natural gas, and telecommunications. In the electric
utilities industry, deregulation had proceeded at a somewhat slower pace. Nevertheless, regulatory changes had been
chipping away utilities monopoly franchises in each of the industrys major segment since 1978. Fourteen years later,
Congress introduced competition into the second segment of the industry, transmission, with the passage of the National
Energy Policy Act of 1992 (NEPA). This act required utilities to make their transmission systems available to third
party users at the same level of quality and cost enjoyed by the utilities themselves. One of the major concerns about
this implementation was whether there would be sufficient transmission capacity.

The municipal agency sued FPL for charging excessive rates and denying fair access to its transmission
system. In October, 1993, FERC interceded and ordered the two parties to negotiate a settlement - the negotiations were
still going on as of May 1994.

Deregulation on the final segment of the industry, distribution, was just beginning in early 1994. Under retail
wheeling, customers would be allowed to buy power from utilities other than the local monopoly supplier. The local
utility would be required to open its transmission and distribution network to outside utilities wishing to sell power in
that market. In the week following this proposal, Californias three largest utilities lost over $1.8 billion of market

b) Decrease in share price

There was some concern about the companys interest expense given the 140 basis point increase in long term
interest rate since September 1993. Historically, bond yields and utility stock prices moved in opposite directions in part
because investors viewed utility stocks with their high dividend yields as bond surrogates and in part because utilities

had relatively high levels of debt and could not pass through all increases in interest expense to consumers. During this
period of rising interest rates and increasing competition, FPLs stock price had fallen by 19.6% while the Standard &
Poors Electric Utilities Index had fallen by 22.1%. Compared to the market as a whole, FPL, like most utilities, was a
low beta stock. Over the prior year, its beta was 0.60.
c) Lowered Rating

On May 5, 1994, Prudential Securities are lowering their rating on FPL Group due to their limited dividend
growth, which is caused by high dividend payout ratio.

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?

The current dividend payout ratio is too high as mentioned in the case, given the competitive, unsecure and
challenging environment that FPL would have to face. FPLs current dividend payout ratio is 91%, which is the highest
ratio among the Electric Power Industry. FPL had its 47 years streak of dividend increases - a record that place it first
among all utilities and third among all publicly traded companies.

The new dividend policy that should be addressed should be based on cutting its current dividend payout ratio
in order to allow the company to achieve better results, perform better, and become a growing firm in the future.
Recently the dividends have been growing faster than the FPLs earnings and therefore, lowering the dividend would
provide more cash for companys growth and reinvestments.

It will be better to use companys earnings for internal growth reasons such as expansions, reinvestments, and
restructuring, to get a competitive advantage over competitors and to hedge against possible future turbulences. The
amount of cash that the company could save, $150 million, could be used to meet future uncertainties regarding retail
wheeling. In the case, we are told that the company would like to expand its business by $6.6 billion with internal
sources. Its important for them to maintain its financial stability for the future and protect profitability and growth. A
lower payout ratio would accelerate investing in profitable projects that would give a boost to shareholders wealth, and
could expand the companys capacity and improve costs.

Rise of deregulations is threatening and should play a significant role in considering changes to the current
dividend policy. As a consequence, this would weaken or even eliminate the monopoly services rights and powers. The
fixed price system might be required for the whole industry. Therefore, in order for the company to protect itself, it
needs to focus on investment opportunities, instead of paying
the majority part of its earnings in the form of dividends.

Although FPL should consider the negative market reaction that normally accompanies dividend cuts and
managements desire not to have to cut the dividend twice, dividend cuts tended to be large when they occurred. One
benefit of a large cut, however, was that FPL could show strong dividend growth for the coming years, which could
attract future investors in the long-run. As mentioned in the case, for example, if FPL was to cut its dividend payout
ratio by as much as 30%, thereby putting it in the lower end of the industry in terms of payout ratios, it could increase
its dividend in in the future years faster than without the cut.
4. From an investor perspective, is FPLs pay out ratio appropriate?

From an investors perspective, FPLs pay out ratio is appropriate because the electric utilities industry is
known for its high dividend pay out ratio. Also, investors perceive FPL as one of the high-end investments in the
electric utilities industry because of its high dividend payout ratio.

As mentioned above, the companies that offer dividends are often companies that have progressed beyond the
growth phase. When companies are no longer able to benefit significantly by reinvesting their profits, they usually
choose to pay them out to the shareholders. Thus, FPLs regular dividends payouts make holding the stock more
appealing to investors. Through the distribution from their earnings, companies indicate a positive future and a strong
performance. However, some shareholders prefer the possibility of higher capital gains in future than dividends. This is
because of the higher marginal tax rate that is associated with dividends vs. the lower effective tax rate which is
associated with capital gains

In synthesis, the investors would think that the payout ratio is appropriate because their awareness of this is
probably one of the reasons why they invested in FPL. Also, they are already enjoying the benefits of this dividends
because it serves as a high and steady income.
5. As Kate Stark, what would you recommend regarding investment in FPLs stock-buy, sell, or hold?

Kate Stark, the electric utilities analyst at First Equity Securities Corporation had issued three weeks ago a
report on FPL Group with a hold recommendation based on the assumption that FPL would keep its dividend at $2.48
per share or increase it slightly.

Kate Stark should recommend to buy back the shares. Given the 6% drop in price, this would be the perfect
time for the investors to buy the shares. Sometime in the future, we could expect that FPLs stock would increase if it
decides to reduce its payout ratio. As mentioned in the case, we believe that the company will cut its dividend policy by
30%, leaving the target payout ratio at 60%. However, in the meantime, the stock price could still go down because of
the negative market reaction associated with payout cut. Cutting back on the payout ratio would give the company extra
cash that they could use for investing on positive NPV projects, as well as meeting future uncertainties regarding retail
wheeling. This growth in future earnings could therefore reflect the stock price through capital gains. To add to this,
buying FPLs shares could provide the investors a steady growing income. To add to this, it could also show strong
dividend growth payout for the coming years.
Corporate Finance Book