Q.

1 DIVIDEND POLICY AT FPL GROUP, INC In 1994 FPL Group, the parent company of Florida Power and Light Company, announced a reduction in its quarterly dividend from $.62 ($2.48 annual) a share to $.42. This was the first-ever dividend cut for a healthy utility, so the company did its best to explain to investors why it had taken such an unusual step. Table 1. Year Dividend per share Earnings per share Dividend payout ratio Dividend payout (%) Earnings per share before extraordinary items Dividend payout ratio Dividend payout (%) 1993 2.47 2.30 1.07 107.39 2.76 0.89 89.49 1992 2.43 2.65 0.92 91.70 2.65 0.92 91.70 1991 2.39 1.48 1.61 161.49 2.66 0.90 89.85 1990 2.34 (2.86) (0.82) (81.82) 2.64 0.89 88.64 1989 2.26 3.12 0.72 72.44 2.99 0.76 75.59 1988 2.18 3.42 0.64 63.74 3.12 0.70 69.87 1987 2.10 3.10 0.68 67.74 2.69 0.78 78.07 1986 2.02 2.90 0.70 69.66 2.90 0.70 69.66 1985 1.94 3.11 0.62 62.38 3.11 0.62 62.38 1984 1.77 2.62 0.68 67.56 2.65 0.67 66.79 Mean 68.23 78.20 Analysing dividend policy of FPL Group we could track some major steps, which leads company to that decision. From table 1, the number shows that FPL has paid very high dividend comparing to the earnings. Dividend has been increased every year. Furthermore, from the record, this company has a 47 years history of dividend increases. We can see that in 1990 dividend payout ratio was increased sharply compare to the previous years. Also, we can see that FPL had a loss in 1990, but the company still increased dividend. Furthermore, in 1991 to 1993 dividend payout ratio was significantly high when compare to the historical data. These sharp changes mostly happen because of the change in the management team. In 1989 McDonald retired from FPL's, and James Broadhead became a new chairman. After analysing industry and future prospects Broadhead concluded that FPL would need to have a commitment to quality and customer service, increase its focus on the utilities industry, expand capacity, and improve its cost position in order to match with the competitive environment. Moreover, FPL needed to renew focus on its core business. It planed to sell several of the non-utility businesses. Furthermore, Broadhead commenced an aggressive capital expenditure program designed to meet projected demand into the next decade. FPL budgeted $6.6 billion, spread over five years, for the expansion. The company also felt that it would be prudent to reduce debt, and that part of the cash savings from the dividend cut would be used for this purpose. At the same time, the company announced plans to return part of the cash saved by the dividend cut by repurchasing up to 10 million shares of stock over the next three years. FPL explained that this would reduce shareholders' taxes. We can say that the dividend changes have been so much less volatile than earnings changes because: 1) management believed that shareholders prefer a steady progression in dividends 2) managers are reluctant to make dividend changes that might have to be reversed. They are particularly worried about a dividend increase, which would affect the stock price. Broadhead needed money to invest in FPL; therefore, he needed to make the stock price increase in order to gain more money when issuing a new stock. Table 2. Electric company FPL Group Carolina Power Duke Power Florida Progress SCANA Corp The Southern Co. TECO Energy, Inc.

Return on common stock 12.50% 13.60% 13.20% 10.90% 12.60% 13.00% 14.30% Earning per share $2.75 $2.23 $2.80 $2.26 $3.72 $1.57 $1.30 Dividend per common stock $2.47 $1.66 $1.84 $1.95 $2.74 $1.14 $0.95 Dividend yield 6% 5% 5% 6% 6% 5% 4% Payout ratio (all dividend) 91% 74% 68% 87% 74% 75% 73% From table 2, we can see that FPL has the highest payout ratio when comparing to the other company in the same area. While FPL's payout ratio was at the high end for electric utilities, the industry was also known for high payout ratio when comparing to the other industries. In previous years, during McDonald era, FPL could pay high dividend because it was a monopoly supplier. It didn't need to keep much retained earning for investing in expansion or development to stay in competition. In Broadhead era, FPL needed more fund to invest in order to compete with the others. FPL's management team has recognized that the company's payout ratio is extremely high comparing to the competitors. The company needed to reconsider the dividend policy in order to match with the new circumstances. FPL may need to retain a larger amount of earnings than usual in order to prepare for possible entry of the new competitors. On the day of the announcement the company's stock price fell nearly 14 percent. Analysts concluded that the action was not an indication of financial weakness, moreover during a month after the announcement the stock price had more than recovered its initial loss. Other benefits brought by this action is: - FPL could show strong dividend growth in the coming years. - As long as earnings increased at a faster rate than dividends, the payout ratio would fall.

Q.2 Will the company require substantial additional retained capital in the few years following May 1994? It depends mainly on whether the company has any new investment opportunities with positive net present value (NPV) in the coming few years. If yes, then the FPL may have to retain more earnings for future projects. However, with regard to the forecast made by the company (Exhibit 6), the capital expenditure will be decreasing from $1.34Billion in 1993 to $0.62B in 1998, which is more than a half. If it is the case, the company probably does not need a huge sum of additional retained earnings. Moreover, the electric utilities industry is going through a deregulation period. The competition of the industry may be very severe, the room for further development may be limited. It is not uncommon for the company with main business in a saturated industry to have high dividend payout ratio and retain only sufficient earnings. Although Broadhead, the new Chairman, had commenced an aggressive capital expenditure program of $6.6Billion designed to meet projected demand into the next decade, the program will be funded by issuing long-term debt and common stock mainly, while only $1B is going to be funded by internal profits. And the program will spread over five years. Therefore, the internal resources of FPL are more than enough to fund this program. Broadhead also decided to focus on the core business and sell some non-utility businesses. If there is a gain on the sale of non-core businesses, the profit may be boost and FPL can develop its business without increasing the ratio of retained earnings substantially. Even there is a loss on the sale, it will still bring cash-inflow to the company and help the liquidity. In the aspect of expenditure, Broadhead had reduced a substantial number of headcount between 1990 and 1993. There might bring some negative impacts on the profit in short term, like incurring a huge sum of redundancy expenses. However, the full positive effect of cost-saving on the profit shall

reveal in the coming years. But one thing we concerned is there is an increasing number of maturing debt in the coming few years (Exhibit 6), the company may need money to repay the debt. Because of the recent rising interest rate environment and the increase of interest spread of the long-term loan of the company, FPL is unlikely to re-finance the existing loan and has to repay them. Even FPL decided to have refinancing, it has to accept an unfavorable term and have the higher interest expenses. Another thing we have to notice is that FPL's retained earnings has been decreasing by 50.3% accumulatively from 1989 to 1993. The ratio of retained earnings to total capital has also been falling from 22.5% in 1989 to 9.9% in 1993.

Q.3 Consider FPL's shareholder base. How might this influence the dividend decision. The Shareholder base consists mostly of individuals, Institutions and then a relatively small number of company employees. Individual shareholders account for about 50% of shares owned by all investors. The Institutions come next with a total of 36.9% of total shares, this consist of Pension Funds, Mutual funds, Financial Institutions and Insurance Companies. Finally there is about 11% of shares owned under the ESOP, this is a program designed to encourage employees to purchase stock in the company. It is used as a retirement savings vehicle. There is a view of dividend policy that starts with the notion that the actions of companies reflect the preferences of their investors, hence shareholders. The clientele model shows that those who pay the lowest level of income tax should own shares with higher dividend yields vice-versa. This is because high dividends would not result in high taxes for these investors as some don't pay tax e.g. pension funds. The conclusion from this is that the pensioners have no tax reason to prefer stock repurchases to dividends. In fact they might actually prefer dividends due to transaction cost. Another reason they may be worse off without dividends occurs when the pensioner lives off this income payments. Technically one can manufacture their own dividend by selling off some shares, but this would incur a transaction cost. Another group that would be indifferent about dividends are financial institutions, these firms operate free of all taxes, both income and capital gains tax, so have no tax reason to prefer either. Corporations would prefer dividends for tax reasons since they pay corporate income tax on only a percentage of dividends received. In contrast they would have to pay tax on the full amount of any realised capital gains. The company would not want to cut dividends if it wanted to appeal to the pensioners, corporations and other institutions that require a high payout (20% of total shares). The other 51% are individuals who are taxed more heavily on dividends than capital gains. In the U.S, they are double taxed. The dividends come out of post tax corporate profits and are also subject to personal tax. This is less extreme in the U.K where only Investors with the highest rates of personal tax are subject to further tax on dividends received. The importance of tax can be seen in the bond market, interest on municipal bonds are not taxed, therefore are sold at low pre-tax yields. However, other bonds that are taxed are sold at higher pre-tax yields. Investors that are heavily taxed would prefer to hold zero yields and they would not want to hold stocks on days they pay dividends. Since they pay less on capital gains made from stock repurchases. There is further tax advantage with share repurchases. There is deferred tax payment, while taxes on dividends have to be paid immediately. Considering those taxed more heavily on dividends, and financial institutions that are indifferent, the company would do well to cut dividends with repurchase stock.

Q.4 The recommendation to James Broadhead should fully explain the importance of the dividend policy and its consequences. Dividends are an additional expense or a loss of funds for a company. The firm's board of directors sets them but they are not compulsory. Payments have to be to all stockholders who are registered on a particular record date. Dividend policy can be seen as the trade off between retained earning and paying cash. But in such a case why managers should choose to pay dividends, as they are not compulsory? Can a reduction in retained earnings damage investments or can a reduction in dividends harm the value of the company? For these two questions there are three groups of people who believe something totally different. The first group believes that an increase in dividends increases the value of the firm. The second group believes that dividend policy makes no real difference so it does not affect the value of the company. Finally there is a third group, which supports that an increase in dividend decreases the value of the firm. Before we decide which of the above groups we are going to support, it is essential to analyse some historical data of that company and similar ones. During the past forty-seven years FPL had a growing dividend yield. This is a sign of a healthy company and it can also be justified by the fact that the company took advantage of the high monopolistic profits. In addition, the management of the company knew that any decline of that dividend yield was expected to decrease the share price. That is based on what had happened on similar companies during the past. For example, Con ed's stock price felt from 18 dollars to 12 dollars in 1972, when the company decreased the dividend per share facing almost the same regulatory situation. It is also important to take into account how mature - efficient is the market that this Group operates. In an efficient stock market as the US one, the performance of a company is one of the major factors that influence the stock price. As a result of that market ethic, any change on dividend policy of FPL group is expected to influence the stock price in a great extent. On the other hand, the deregulation of the market is expected to decrease its market share and as a result its profits. The company is not expected to take advantage of the high monopolistic oligopolistic profits any more. As a result, retained earnings are expected to decline, leaving no space for higher divided payments. In such a case, it may be better for the company not to increase its dividend payments, and in case the retained earning may not be needed, the company can pay even higher dividends the following years. Summarising the above, we believe that an increase in dividend payment increases the value of the company. In other words, the company should not change the policy of the past 47 years and continue to increase the dividend payments. Similar cases of the past show that any decline on the dividend payments influences the stock price negatively. Moreover, the company has already made some investments, which are expected to mature in the following years and as a result no significant capital expenditures is required. (Exhibit 6- forecasts). Finally, we believe that the company's profits will not be harmed from competition. The reason is that the basic power-network belongs to it, and the company can charge other companies to use it in a profitable way (without harming the competition). So we are advising James Broadhead to declare a dividend higher than 2.47 dollars per share.

Q.5 Fully explaining your answer, what recommendation should Kate Stark give to her investors -buy, hold or sell- on 5th May 1994? In order to answer this question, we need to look at factors which would induce investors to BUY a share in FPL Group on the 5th May 1994, and factors which would induce them to SELL. Once we have done that, we will be in a better position to judge which factors outweigh which, and thus decide whether it is better to buy, hold or sell. 1. Positive Factors

Competent management: When Broadhead joined FPL Group, the company was under the strain of major structural and strategic problems. It had a number of businesses unrelated to its core electric skills, and its spiralling costs had resulted in electric rates among the highest in the country. The company could no longer meet the fast growing demand, and employees were suffering from low morale. Based on his experience in the natural resources and telephone industries, Mr. Broadhead changed the culture, structure and long-term strategy of the company. Thanks to these changes FPL Group became a focused, operational rather than bureaucratic, relatively flat business, with competition at the heart of its strategy. Sound financial position: by 1994, the group was the largest utility in Florida, with record results in 1993, and 1994 expected to be even better due to decreasing capital expenditures and increasing sales. In short, from a financial point of view, and looking at the financial statements of the company for 1993, the group seems to represent a healthy business with a sound structure and long-term strategy, that would see it go through the deregulation of the industry without major distress. Competitive position: FPL is likely to be amongst the winners from deregulation because of its intelligent long-term competitive strategy. Positive effects of a dividend cut: if it is true that the group will decide to cut its dividend, then this decision must have strategic implications for the long-term growth of the utility. A dividend cut will: create more alternative sources of capital (retained earnings) allow the company to reduce its debt ratio, and thus its interest payments. allow the company to exploit more investment opportunities, instead of paying most of it earnings as dividends. bring FPL's payout ratio to the industry's average, and allow for higher future dividend growth. redefine FPL as a growth company in an unregulated environment rather than an income company with a monopoly in its market. 2. Negative Factors Increasing competition in the electric utility industry, combined with greater business risk and lower bond ratings. Higher potential for agency problems with dividend cuts, as managers will have more cash to spend on unprofitable projects or on their own pleasures. The new incentive plan does not really help with this problem, as bonuses would be paid out in stock and cash in the ratio 60/40 down from a ratio of 70/30. Dividend cuts were not common for utilities except in situations of financial trouble. The company had also the option of growing out of its high payout ratio, why choose to cut its dividends instead? It was not clear what the group was intending to do with the cash in the case of a dividend cut. The market does not usually respond very well to a dividend cut, two examples have been given in the case: Consolidated Edison Company of New York, and Sierra Pacific Resources whose stock dropped by 23% and its shareholders sued. Signaling Hypothesis: managers have better information about a firm's future prospects than public stockholders do. Since future dividends are paid out of future profits, and given that managers are reluctant to cut dividends, any change in dividends to be paid is often viewed as a signal of future profits. Thus, increases in dividends generally result in stock price increases and cuts in dividends generally result in stock price declines. The clientele effect: different clienteles of stockholders prefer different dividend payout ratios. Firms have different payouts based on their own internal business needs. Thus, when a firm switches its payout ratio, perhaps due to business imperatives, the current clientele leaves and another clientele must come in to take its place. If more investors leave or if they leave quicker than the new clientele enters, this could lead to a temporarily depressed share price.

3. Evaluation We have looked at both positive and negative factors that could influence the share price and market value of FPL Group. On May the 5th the price had already fallen by 6%, apparently because of the Merrill Lynch report. If other analysts decided to downgrade FPL Group, this could have a dramatic effect on the share price. If the dividend cut is really on prospect, than the share price would fall regardless of the reasons behind this cut, whether they are really for strategic growth or financial trouble. What is harder to predict is by how much the share price would fall, and for how long it would fall. From a financial perspective the company seems to be financially healthy and offers many prospects for growth and profitability in the future, especially if we consider its eagerness to prepare itself for the coming of competition to the industry. From a managerial perspective, the company seems also to be well managed, although the compensation plans work too much in the favor of managers. Thus, from an investment perspective the company seems to be a good investment, if we do not consider the effects that a dividend cut would have on the share price and the market value of the company. Therefore, we can see that the main problem comes from the possible effects of a dividend cut, and not from the financial health and risk of the business itself. In fact, a dividend cut would very much help the company at the moment in order to increase financial flexibility in the new era of deregulation, reduce leverage ratio in preparation for increased business risk and provide resources for future growth opportunities. So the dilemma we are faced with is whether it is possible for the company to adjust its dividend policy for valid business reasons and avoid a significant temporary or semi-permanent decline in its value. On the one hand, Kate could advise her clients to buy the share, on the basis that the price has already fallen, we do not know if it will fall further, and we do not even know that there will definitely be a dividend cut. Because we expect the company to do well in the future, investors can expect to make a capital gain, as the share price will go up. On the one hand, Kate could advise her clients to sell the share, or even short sell it, for a short time, on the basis that the price will fall further on the announcement of a dividend cut, and then buy again when the price is cheap enough, and the company becomes a growth rather than an income investment. However, this will be a very risky route to take. What we can see is that in both these cases the investors will end up with the shares of FPL Group for a long-term investment, because there are significant signs that the company offers good growth prospects. 4. Recommendation From the analysis and evaluation carried out on the previous sections, we believe that Kate Stark should recommend to her investors to HOLD their shares in FPL Group on the 5th May 1994. The reasons for this choice are that the company offers good growth prospects, but the price could decline further in the short term, so it would not be profitable to buy at that date, and it would be very unprofitable to sell for the long-term. Q.6 What dividend decision did FPL make in May 94? How did the share price respond to this announcement in both the short and long terms? Do you think that the market responded rationally to the news? As soon as the report by Merrill Lynch's utilities analyst was published, FPL's stock price tumbled by more than 6%. However this did not deter FPL's management from taking the unprecedented step to

reduce dividend payout to 42 Cents per share ($1.68 annually), a 32% reduction from the previous dividend of 62 Cents ($2.48 annually). The company also felt that it would be prudent to reduce debt, and that part of the cash savings from the dividend cut would be used for this purpose. The management's plan also called for a common stock repurchase program. FPL Authorised the repurchase of 10 million shares over the next three years. It would purchase at least 4 million shares in the first 12 months. Finally FPL promised an earlier annual dividend review. To more closely link dividend action to annul earnings, the dividend rate will be evaluated in February, starting in 1995. The company previously evaluated the dividend rate in May, in conjunction with its annual meeting. Although all this sounded logical, the news initially surprised investors, who hammered FPL's stock down 14%. Which seems rational since this was the first-ever dividend cut by the company. Most investors view dividends as anticipating future earnings, it's no wonder that such a cut in dividends should be taken by investors as bad news causing the stock price to fall. FPL is undoubtedly a healthy utility, so the company did it's best to spell out to investors why it had taken such an unusual step. FPL pointed to the prospect of increased competition in the industry, and argued that the company's historically high payout ratio was no longer in shareholder's best interest. Along with the debt reduction plan and share repurchase program outlined above FPL explained that this would reduce shareholders' taxes. Once the initial shock wore off and analysts considered FPL's reason for the dividend cut they concluded that the company wasn't forced to cut it's dividend due to short term financial weakness, but rather as a strategic decision to cut the dividend level to reflect the need for more financial flexibility in an increasingly competitive and deregulated utility environment. As should be expected in a rational market, within a month of the announcement, the stock price had more than recovered it's initial loss.