Case 3 Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

FIN500

Dividend Policy at FPL Group, Inc.

Executive Summary 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 A way of keeping managers in check and mitigating agency problems when high retained earnings dont 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 Tbonds 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 + (RM - Rf) = 0.60 (RM - Rf) = 7.5% Rf = 7.3% i = Rf + (RM - Rf) = 7.3% + 0.60 * 7.5% = 7.3% + 4.5%= 11.8%

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Case 3 FPL Group Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi 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%

FIN500

3. From FPLs 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. The case notes that the company was paying out in the range 90% of its earning. FPL will be better off saving those extra earnings for the purposes 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. 4. From an investors perspective, is the FPLs payout ratio appropriate? Explain and justify your answer based on information in the case. Well according to the case, the payout by FPL is appropriate, the case further emphasized that investors are use to getting high payout from the utility companies. Looking at the case, it was reported that after FPL announced of 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 $4.375 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 postannouncement 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 a 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. 5. As Kate Stark, what would you recommend regarding investment in FPLs stock buy, sell, or hold?
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Cornett, Marcia, Adair, Troy, and Nofsinger, John. Finance: Theory and Applications. 2009: United States. McGraw-Hill Irwin. p. 495.

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