It is Worth Noting That
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It is worth noting that, although management can use changes in dividends as a signal to convey information to the market, in some cases dividend changes may be an ambiguous signal. This can be illustrated through the case of FPL Group, the parent company of Florida Power& Light Company (see, Soter, Brigham and Evanson, 1996). On May 9, 1994 FPL announced a 32 percent cut in its quarterly dividends. The market responded negatively to the announcement and FPL’s stock price dropped by about 20 percent, because the market perceived it as a signal of bad future prospects. However, the FPL board had in fact decided to retain funds for new investments to improve the company’s future performance. After realizing the reason for the dividend reduction, financial analysts concluded that the action was not a signal of financial distress. Thereafter, FPL’s stock price recovered. The market was initially mistaken but the case is a good example of the possible (and sometimes contradictory) signalling effects of dividend announcements.
Dividend Policy at FPL Group, Inc. (A) & (B) 1. A) Why do firms pay dividends? Firms pay dividends depending on their financing and investment decisions. If they plan on financing through borrowing, then that releases cash for dividends in order to eliminate having large cash balances on hand. In addition, dividends are an immediate cash payment to the stockholder that they can spend or reinvest. B) What, in general, are the advantages of paying dividends? Dividend payments can be considered advantageous as signaling devices in the market. If dividends increase, it is interpreted that the company’s value has increased and the stock goes up. If the earnings decrease and the company continues to pay the regular dividends, this makes the statement that the company is sound and the decrease is temporary and in the long run the money will be there. If the company pays out too much, then they can replace the cash by issuing new stock at no cost without signaling consequences. C) What are the disadvantages of paying dividends?
Dividend payments can be a disadvantage in the market as a signaling device. If dividends decrease, it is interpreted that the company’s value has decreased. This can cause the investors to sell the stock and send the price down in the market. Another disadvantage is that paying dividends may result in selling new stock if the earnings retained are reduced or exhausted. This can lead to fewer earnings for the stockholder. Furthermore, dividends are taxed as ordinary income. 2. A) What are the most important issues confronting the FPL Groups in May 1994? The most important issues confronting FPL Groups are: • The effect that retail wheeling will have on FPL if it is authorized by the Florida Public Service Commission is that it could bring about fierce competition from large investor-owned utilities in neighboring states. Florida’s 4 major investor-owned utilities are providing 73% of the state’s generating capacity, 20 municipal and rural cooperative generating systems are generating 24% capacity, and 19 independent power producers, which includes qualifying facilities, are generating 3% capacity. This competition could decrease their market value. • Even though its financial performance is improving, there is concern about interest expense as there has been a 140 basis point increase in long-term interest rates since September 1993. From September 1993 to May 1994, FPL’s stock price fell by 19.6% and the S&P’s Electric Utilities Index had fallen by 22.1%. B) What are the issues in setting dividend policy? When managers set dividend policy they decide the policy that best meets their companies needs. According to William R. Lasher in Practical Financial Management (p 550), the three common policies are:
• Target payout ratio – the firm selects a long-run payout ratio that’s comfortable. The payout ratio stays below the target in order to allow for variations in earnings that does not force a decrease in dividends. • Stable dividend per share – The dividend remains constant regardless of earnings unless there is evidence of financial trouble and payment of dividends is in doubt. As long as things are going well with the company and its growth, then dividends can be raised. • Small regular dividend with a year-end extra if earnings permit – This policy assures stockholders of a regular dividend, and can either pay or forgo the year-end extra. FPL has been using the stable dividend per share policy in such that it has paid dividends regularly, and consistently increased the dividends to a high payout ratio in the industry. As the company makes changes to their policy, their goal is to align their financial strategy with their competitive strategy which means a decrease in dividends. Per the Dividend Policy at FPL Group, Inc. (B), the issues surrounding this change in policy are: • Reduction of the dividend by 32% ($248 to $1.68) will increase the cash flow by approximately $145 million per year; and establish a new target dividend payout ratio of 60% to 65% of prior year’s earnings. • Begin a repurchase program: FPL will buy ten million common shares over the next three years and at least four million shares in the next twelve months. • Move the dividend review from the annual meeting in May to February in order to link the dividend and annual earnings announcements more closely 3. A) From FPL’s perspective, is the current payout ratio appropriate? FPL has decided that its dividend payout is inappropriately high with the ratio at 91% in 1993. Due to the increasing risks in the industry, such as deregulation, there is a cause for uncertainty. Investor-Owned Utilities in the Southeast U.S. in 1993 (from Exhibit 7) Utilities Payout Ratio Dividend Yield FPL Group 91% 6% Carolina Power 74% 5% Duke Power 68% 5%
Florida Progress 87% 6% SCANA Corp. 74% 6% The Southern Co. 75% 5% TECO Energy, Inc. 73% 4% B) Would a higher payout be more appropriate (substantiate your position)? No, FPL is already at the high end of the payout for electric utilities and to increase the payout would not be in their best interest. A higher payout would decrease their financial flexibility and decrease their cash flow. One way for FPL to ensure their financial flexibility is to decrease the dividend payout ratio by 25% to 30%, which will increase the cash flow by approximately $145 million per year {Dividend Policy at FPL Group, Inc. (B)}. 4. From an investor’s perspective, is FPL’s payout ratio appropriate (substantiate your position)? Some investors would see the high payout ratio as appropriate in that FPL is returning excess cash to the stockholders. In addition they are controlling 92% of the market in residential and commercial customers in the Southeast U.S. FPL would be positive for investors who are looking for a high payout they can live on and a company that is carrying the majority of the industry in their area. The investor, who is looking for a lower tax, would rather invest in a company with a smaller payout ratio. A financially sound company with a low payout ratio are normally, reinvesting their cash in the company to increase their earnings. Investor-Owned Utilities in the Southeast U.S. in 1993 Utilities Residential Commercial
FPL Group 56% 36% Carolina Power 33% 20% Duke Power 33% 24% Florida Progress 47% 28% SCANA Corp. 43% 29% The Southern Co. 32% 26% TECO Energy, Inc. 44% 30% 5. A) As Kate Stark, what would you recommend regarding investment in FPL’s stock—buy, sell or hold? B) Why? As Kate Stark, I would recommend buying FPL stock as the market drops. When dividends are cut, the market reacts negatively and the price drops. FPL has a payout of 91%, with a dividend yield of 6%, which is well above the industry groups and it ranks within the top five electric utilities companies. If it cuts dividends by 30%, it would remain within the top 5 of the industry groups, but it would rank at the lower end of the utilities companies. Industry Rankings before FPL cuts Industry Rankings if FPL cuts 30% Industry Dividend Dividend Industry Dividend Dividend Groups Payout Ratio Yield Groups Payout Ratio Yield FPL (utilities) 91% 6% Healthcare (drugs) 69.4% 4.1% Healthcare (drugs) 69.4% 4.1% Household Products 66.9% 2.6% Household Products 66.9% 2.6% Tobacco 65.7% 5.2% Tobacco 65.7% 5.2% FPL (utilities) 61% 6% Publishing(newspap) 58% 3% Publishing(newspap) 58% 3%
Utilities Rankings before FPL cuts Utilities Rankings if FPL cuts 30% Utility Dividend Dividend Utility Dividend Dividend Companies Payout Ratio Yield Companies Payout Ratio Yield Texas Utilities 106.2% 9.6% Gen. Public Utilities 65.5%. 6.6% Oklahoma G&E 93.3% 8.6% Duke Power 64.8% 5.3% Potomac Electric 92.2% 8.7% Centerior Energy 61.5% 7.7% FPL 91% 6% FPL (utilities) 61% 6% Houston Industries 90.9% 10% Philadelphia Elec. 60.8% 5.8% This would give the company the ability to increase its dividends in the future years at a faster rate. The cash result of not paying dividends could be used for investments and debt reduction. Therefore, if dividends are cut, I would recommend buying as FPL is using the dividend cuts as a strategy to strengthen its financial structure. 6. A) As Broadhead, would you cut the dividend or increase it? B) Please give ample supporting evidence to justify your position. I would decrease the dividend. Even though deregulation has not been authorized in Florida at this time, the industry is facing changes due to expectation of it in the near future. FPL has to be financially and competitively ready for whatever changes happen. The firm has to maintain a financial flexibility and a high payout ratio can limit this. To slow the dividend growth and grow out of the high payout ratio would not be in the best interest of the stockholders as it would take several years, and cash that is freed up now can be used to reduce debt levels {Dividend Policy at FPL Group, Inc. (B)}. In addition, the stock price will drop and during this time FPL can buy back their stock at a lower price.
In early 1994, FPL had become the largest utility in Florida (and the fourth largest in the country), provided power to 3.4 million customer accounts, and had a service territory covering almost 28,000 square miles. Financially, 1993 had been a record year for FPL; not counting a one-time charge for layoffs related to the cost reduction program, net income was $514 million or $2.75 per share. This was expected to continue with 1994 being better due to decreasing capital expenditures and increasing sales. In 1993 Sales was 72,455 and capital expenditures was 1,337. The projected for 1994 is sales at 74,411 and capital expenditures $901. This constitutes an increase in sales of 26 % (74,41172,455/74,411) and a decrease in capital expenditures of 32.6% (1,337901/1,337). The changes previously made for the company has improved its operating efficiency dramatically and decreasing the dividend is preparing FPL for future improvements.
Dividend Policy at FPL Group, Inc. (A) & (B) 1. A) Why do firms pay dividends? Firms pay dividends depending on their financing and investment decisions. If they plan on financing through borrowing, then that releases cash for dividends in order to eliminate having large cash balances on hand. In addition, dividends are an immediate cash payment to the stockholder that they can spend or reinvest. B) What, in general, are the advantages of paying dividends? Dividend payments can be considered advantageous as signaling devices in the market. If dividends increase, it is interpreted that the company’s value has increased and the stock goes up. If the earnings decrease and the company continues to pay the regular dividends, this makes the statement that the company is sound and the decrease is temporary and in the long run the money will be there. If the company pays out too much, then they can replace the cash by issuing new stock at no cost without signaling consequences. C) What are the disadvantages of paying dividends?
Dividend payments can be a disadvantage in the market as a signaling device. If dividends decrease, it is interpreted that the company’s value has decreased. This can cause the investors to sell the stock and send the price down in the market. Another disadvantage is that paying dividends may result in selling new stock if the earnings retained are reduced or exhausted. This can lead to fewer earnings for the stockholder. Furthermore, dividends are taxed as ordinary income. 2. A) What are the most important issues confronting the FPL Groups in May 1994? The most important issues confronting FPL Groups are: • The effect that retail wheeling will have on FPL if it is authorized by the Florida Public Service Commission is that it could bring about fierce competition from large investor-owned utilities in neighboring states. Florida’s 4 major investor-owned utilities are providing 73% of the state’s generating capacity, 20 municipal and rural cooperative generating systems are generating 24% capacity, and 19 independent power producers, which includes qualifying facilities, are generating 3% capacity. This competition could decrease their market value. • Even though its financial performance is improving, there is concern about interest expense as there has been a 140 basis point increase in long-term interest rates since September 1993. From September 1993 to May 1994, FPL’s stock price fell by 19.6% and the S&P’s Electric Utilities Index had fallen by 22.1%. B) What are the issues in setting dividend policy? When managers set dividend policy they decide the policy that best meets their companies needs. According to William R. Lasher in Practical Financial Management (p 550), the three common policies are:
• Target payout ratio – the firm selects a long-run payout ratio that’s comfortable. The payout ratio stays below the target in order to allow for variations in earnings that does not force a decrease in dividends. • Stable dividend per share – The dividend remains constant regardless of earnings unless there is evidence of financial trouble and payment of dividends is in doubt. As long as things are going well with the company and its growth, then dividends can be raised. • Small regular dividend with a year-end extra if earnings permit – This policy assures stockholders of a regular dividend, and can either pay or forgo the year-end extra. FPL has been using the stable dividend per share policy in such that it has paid dividends regularly, and consistently increased the dividends to a high payout ratio in the industry. As the company makes changes to their policy, their goal is to align their financial strategy with their competitive strategy which means a decrease in dividends. Per the Dividend Policy at FPL Group, Inc. (B), the issues surrounding this change in policy are: • Reduction of the dividend by 32% ($248 to $1.68) will increase the cash flow by approximately $145 million per year; and establish a new target dividend payout ratio of 60% to 65% of prior year’s earnings. • Begin a repurchase program: FPL will buy ten million common shares over the next three years and at least four million shares in the next twelve months. • Move the dividend review from the annual meeting in May to February in order to link the dividend and annual earnings announcements more closely 3. A) From FPL’s perspective, is the current payout ratio appropriate? FPL has decided that its dividend payout is inappropriately high with the ratio at 91% in 1993. Due to the increasing risks in the industry, such as deregulation, there is a cause for uncertainty. Investor-Owned Utilities in the Southeast U.S. in 1993 (from Exhibit 7) Utilities Payout Ratio Dividend Yield FPL Group 91% 6% Carolina Power 74% 5% Duke Power 68% 5%
Florida Progress 87% 6% SCANA Corp. 74% 6% The Southern Co. 75% 5% TECO Energy, Inc. 73% 4% B) Would a higher payout be more appropriate (substantiate your position)? No, FPL is already at the high end of the payout for electric utilities and to increase the payout would not be in their best interest. A higher payout would decrease their financial flexibility and decrease their cash flow. One way for FPL to ensure their financial flexibility is to decrease the dividend payout ratio by 25% to 30%, which will increase the cash flow by approximately $145 million per year {Dividend Policy at FPL Group, Inc. (B)}. 4. From an investor’s perspective, is FPL’s payout ratio appropriate (substantiate your position)? Some investors would see the high payout ratio as appropriate in that FPL is returning excess cash to the stockholders. In addition they are controlling 92% of the market in residential and commercial customers in the Southeast U.S. FPL would be positive for investors who are looking for a high payout they can live on and a company that is carrying the majority of the industry in their area. The investor, who is looking for a lower tax, would rather invest in a company with a smaller payout ratio. A financially sound company with a low payout ratio are normally, reinvesting their cash in the company to increase their earnings. Investor-Owned Utilities in the Southeast U.S. in 1993 Utilities Residential Commercial
FPL Group 56% 36% Carolina Power 33% 20% Duke Power 33% 24% Florida Progress 47% 28% SCANA Corp. 43% 29% The Southern Co. 32% 26% TECO Energy, Inc. 44% 30% 5. A) As Kate Stark, what would you recommend regarding investment in FPL’s stock—buy, sell or hold? B) Why? As Kate Stark, I would recommend buying FPL stock as the market drops. When dividends are cut, the market reacts negatively and the price drops. FPL has a payout of 91%, with a dividend yield of 6%, which is well above the industry groups and it ranks within the top five electric utilities companies. If it cuts dividends by 30%, it would remain within the top 5 of the industry groups, but it would rank at the lower end of the utilities companies. Industry Rankings before FPL cuts Industry Rankings if FPL cuts 30% Industry Dividend Dividend Industry Dividend Dividend Groups Payout Ratio Yield Groups Payout Ratio Yield FPL (utilities) 91% 6% Healthcare (drugs) 69.4% 4.1% Healthcare (drugs) 69.4% 4.1% Household Products 66.9% 2.6% Household Products 66.9% 2.6% Tobacco 65.7% 5.2% Tobacco 65.7% 5.2% FPL (utilities) 61% 6% Publishing(newspap) 58% 3% Publishing(newspap) 58% 3%
Utilities Rankings before FPL cuts Utilities Rankings if FPL cuts 30% Utility Dividend Dividend Utility Dividend Dividend Companies Payout Ratio Yield Companies Payout Ratio Yield Texas Utilities 106.2% 9.6% Gen. Public Utilities 65.5%. 6.6% Oklahoma G&E 93.3% 8.6% Duke Power 64.8% 5.3% Potomac Electric 92.2% 8.7% Centerior Energy 61.5% 7.7% FPL 91% 6% FPL (utilities) 61% 6% Houston Industries 90.9% 10% Philadelphia Elec. 60.8% 5.8% This would give the company the ability to increase its dividends in the future years at a faster rate. The cash result of not paying dividends could be used for investments and debt reduction. Therefore, if dividends are cut, I would recommend buying as FPL is using the dividend cuts as a strategy to strengthen its financial structure. 6. A) As Broadhead, would you cut the dividend or increase it? B) Please give ample supporting evidence to justify your position. I would decrease the dividend. Even though deregulation has not been authorized in Florida at this time, the industry is facing changes due to expectation of it in the near future. FPL has to be financially and competitively ready for whatever changes happen. The firm has to maintain a financial flexibility and a high payout ratio can limit this. To slow the dividend growth and grow out of the high payout ratio would not be in the best interest of the stockholders as it would take several years, and cash that is freed up now can be used to reduce debt levels {Dividend Policy at FPL Group, Inc. (B)}. In addition, the stock price will drop and during this time FPL can buy back their stock at a lower price.
In early 1994, FPL had become the largest utility in Florida (and the fourth largest in the country), provided power to 3.4 million customer accounts, and had a service territory covering almost 28,000 square miles. Financially, 1993 had been a record year for FPL; not counting a one-time charge for layoffs related to the cost reduction program, net income was $514 million or $2.75 per share. This was expected to continue with 1994 being better due to decreasing capital expenditures and increasing sales. In 1993 Sales was 72,455 and capital expenditures was 1,337. The projected for 1994 is sales at 74,411 and capital expenditures $901. This constitutes an increase in sales of 26 % (74,41172,455/74,411) and a decrease in capital expenditures of 32.6% (1,337901/1,337). The changes previously made for the company has improved its operating efficiency dramatically and decreasing the dividend is preparing FPL for future improvements.
