Wednesday, April 2, 2008

Case: Dividend Policy at FPL Group Inc

Date: March 02, 2006

Student Name: Pham Thi Thuy Ha Student ID: 2A5026

Why do firms pay dividend?:

- Firms pay dividends to balance their asset and capital structures when their earnings outstrip their investment opportunities.

- Firms pay dividends to mitigate agency problems when they have excess earnings.

Cons of cash dividend payment:

- A dividend policy is irrelevant or has no impact on the firm’s value because investors have the ability to create "homemade" dividends.

- Little to no dividend payout is more favorable for investors. This is because taxation on a dividend is higher than tax on capital gains.

- Dividends are taxed as ordinary incomes

- Dividends can reduce internal source of financing

- Once established, dividends cuts are hard to make without adversely affecting a firm’s stock price

Pros of cash dividend payment:

- Cash dividends can underscore good results and provide support to stock price

- Dividends may attract institutional investors who preferred some returns from dividends

- Stock price usually increases with the announcement of a new or increased dividends

- Dividends absorb cash flow so they may help reduce agency problems

Major issues of FPL in 1994:

- Negotiation between FPL and FERC (Federal Energy Regulatory Commission) to settle the lawsuit against FPL for changing excessive rates and denying fair access to its transmission system.

- Lower investment rate due to the fact that FPL probably does not raise dividends as discussed

- Suggestion of dividend cuts by FPL’s managers

- FPL’s stock price has fallen by 19.6% while the S&P index has decreased by 22.1%

- Rising interest rate and increasing competition in electric industry

From investors’ perspective, the current payout ratio is appropriate to some extent:

- FPL’s current payout ration = cash dividend/net income = 461693/248749 = 107.7%. According to the exhibit 9, FPL has the highest payout ratio in comparison to other electric utilities in the same industry.

- For institutional investors who hold 36.9% of FPL’s total common stocks, this payout ratio may be appropriate because they likely prefers high payout ratio in seeking for high earnings from their investment. If FPL tries to maintain this ratio, it can satisfy those small investors but it has to increase this ration over time to satisfy these investors’ expectation.

- For individual investors who hold 51.9% of FPL’s total common stocks, the payout ration has little meaning because they can use homemade dividend strategy to obtain capital gains rather than receive cash dividends due to higher taxes imposed on dividends. Furthermore, they do not need dividends to convert shares to cash. FPL’s decision to cut payout ration does not really affect the value of these individual investors.

- In my opinion, FPL currently maintains an inappropriate payout ration. Given the situation that the new regulation will be soon implemented, FPL will face strong competition not only from Florida but also from all other possible states. FPL can not protect itself by restricting access to its transmission system since it was sued for doing so. To prepare for competition and sustainable growth in near future, the best way FPL can do is to use its excess cash to invest in new positive NPV projects. Therefore, FPL should not maintain the high payout ration at 107.7%. Instead, it should lower this ratio to or below the average ratio of the industry (82.9%) since the dividend cut does not lower the firm’s value.

Recommendations on FPL’s stocks:

- First, FPL should declare to cut dividends. The company should not worry about a lawsuit against its lower dividend policy as the dividend cut does not affect the majority of its investors (individual investors). Upon the announcement of dividend cut, the stock price can decrease so FPL should use its excess cash to buy back its stock to increase the stock price whenever it falls down.

- Then, FPL should use Buy and Hold strategy to repurchase its stocks and hold them regardless of market fluctuations. This solution as a long term investment can help FPL increase its stock price which has fallen in early 1994. By doing so, FPL can get rid of its excess cash of $150 million per year. FPL also can use this strategy to increase incentive compensation by granting stock options to employees and thus, increase employment commitment and recruiting attractiveness to have competent personnel for future growth.

- FPL should use its excess cash to invest more in new profitable projects, acquire new companies and profitable assets, and reinvest in financial assets.

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