Dividend Policy at Fpl Group Essay

The FPL Group was Florida’s largest electric utility group and the fourth largest in America. The FPL Group had annual revenues of exceeding $5 billion. Florida Power & Light Company, the main subsidiary of the FPL Group had 3.9 million customer accounts and covered a service area that included six of America’s ten fastest growing metropolitan areas. a. Summarize the key elements of FPL’s financial policy and compare it with other relevant firms. We are commenting on FPL’s financial policy from a dividend and capital structure perspective. FPL has a very high dividend payout ratio of around 90% and has a 47 year streak of dividend increases. FPL’s dividend payout ratio is also high from a relative comparison as the average payout ratio among power utilities in America is around 80%. When compared with the payout ratio of power utilities in the southeast of America, this seems even higher as the average for utilities operating in the same geography as FPL operates in is around 77%.

As regards the capital structure, FPL operates with a Debt to total assets ratio of 46.4% which is consistent with other utilities in the same geography. b. What are the issues the FPL must consider in choosing how much cash to distribute to investors? The power landscape is in a situation where significant regulatory changes are expected. The power sector is poised towards rapid deregulation, resulting in the possibility of increased competition in the near future. The immediate anticipated threat comes from retail wheeling which would allow the deregulation of the power distribution business. Though the possibility of retail wheeling in Florida in the immediate term is low considering the fact that state’s electricity regulatory commission is yet to consider the introduction of retail wheeling, the general industry trend hints that retail wheeling is a distinct possibility sooner rather than later.

This would mean intense competition and may open up FPL to pricing pressure and in an adverse situation, losses. Such a situation has already been witnessed in California’s utility companies post introduction of retail wheeling in their state. In light of the situation mentioned above, FPL has to ensure that it has the resources available to meet future competition where one of the determinants of winning or retaining new business may be price. Hence, its dividend payout policy must be modified to account for these industry changes. c. How should FPL choose between dividends and share repurchases as alternative modes of payment? The Modigliani-Miller clearly postulates that the dividend policy is irrelevant. The value of the assets of FPL should be independent of the financial structure of the firm.

Also, the choice of dividend payments or share repurchases should not influence the share price as both methods are ways to distribute cash to the shareholders. However, this is true only in the Modigliani-Miller world where there are no costs related to taxes or financial distress. In practice, dividend policy will be affected by taxes as tax rates for different categories of investors will differ. Also, a firm’s dividend policy is perceived by the financial markets to be a signaling mechanism. A cut back in dividends may signify that the firm perceives tough conditions in the future and this may result in a decrease in the firm’s share price. Purely with regards to the choice between dividend payout and share repurchases, FPL should choose the mechanism that is most tax efficient.

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Around 18% of shares are held by Pension funds that are tax exempt. In the case of individuals who constitute the largest shareholder category, the dividend policy will not really matter as in the absence of dividends, they can always sell shares to realize cash. However, from a tax perspective, generally capital gains are taxed at a rate lower than personal income tax which adds dividends to taxable income. Also, a share repurchase may signal to the investors that the shares are undervalued and hence may see a spurt in share price. It is prudent to sacrifice short term gains for long term stability.

d. What specific changes would you recommend to FPL’s financial policies, and why? We propose that dividend payouts be reduced immediately. Also, for the current year, we propose that the reduced dividend payouts are made in the form of share repurchases. The lowering of dividend payouts is proposed considering the fact that FPL has to protect its future earnings in light of anticipated competition due to deregulation of the power sector in Florida. Hence, cash would need to be conserved to buffer in unanticipated future challenges.

While in all likelihood the reduced dividend payouts would be negatively viewed by the market and hence would see erosion in share price, a subsequent share repurchase would send a signal to the market that the company expects its profitability to be sustained in future. We recommend a 30% cut in the payout ratio from 90% to 60%. This would immediately place FPL at the lower end of the dividend spectrum among utility companies. While, this should reduce the share price, our simultaneous proposal to announce a share repurchase should see the share price rebound to the existing level of $32.

New Policy (cut in dividend payout to 60% and distribution by way of share repurchase)

Assumptions:

1. There is no change in the capital structure. Hence, the cost of equity remains the same 2. Risk free rate is assumed to be the yield on 30 year US treasury bond 3. Market risk premium is assumed to be at 6%. This is based on historical data and industry practice. The equity Beta is already given as 0.60 in the case.

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