Question 1
The most important issues confronting the FPL Group is whether to review their dividend policy. FPL has employed a high dividend policy over the years. The dividends pay-out has been increasing consistently in the last 47 years. 1993 was a best year for the group which saw it record the highest revenue. Management expected the company perform better in 1994. However, events took another turn. It was expected that Florida may allow Retail Wheeling which will significantly increase competition and change the entire competitive landscape in the industry. Therefore, management of FPL Group feel that the dividend pay-out of 2.58 for every share is too high. The dividend pay-out was more than 90 per cent in 1993. Given the increasing risks facing the utility industry, management feel that the dividend pay-out ratio is unsustainable. FPL Group has two alternative; to grow out of the high dividend pay-out by increasing its net income at a faster rate than the rate of increase in dividend pay-out or cut dividends. Both alternatives have repercussions. Already, several utilities analysts, including Merrill Lynch’s utilities analyst and Prudential Securities utilities analyst were contemplating lowering the investment rating of the company. Therefore; utilities analysts anticipate that management of FPL Group may not raise the dividend pay-out in the next annual general meeting in May. In addition, the share price of FPL Group had reduced by 6 per cent. The reduction in the share price of FPL Group could be attributed to the expected stagnation or reduction in dividend pay-out. Therefore, FPL Group needs to tread carefully to cushion the share price and consequently the market value of the firm.
Question 2
Reducing the dividend pay-out is likely to increase shareholders value even in the face of increased competition. Taxes on capital gains are lower than taxes on dividends pay out. Theoretically, companies that pay high dividends result in lower shareholder value compared to companies that pay lower dividends. By paying low dividends, a company is able to invest the retained funds in profitable projects with a positive net present value thus increasing the residual value of the firm. Increase in the value of a firm will be passed to shareholders in the form of capital gains which attracts a lower tax rate than dividends. Considering the current situation of FPL Group, the much needed funds could be invested in projects that would diversify the revenue streams and protect the market share of FPL Group in Florida.
If Retail Wheeling is allowed in Florida, FPL Group will face increased competition thus creating a need to invest in projects that will improve is corporate image. FPL Group may engage in Corporate Social Responsibility (CSR) by improving the environment and improving social welfare of the Florida Community. This will make consumers identify with the company thus creating loyal customers. Unfortunately, this can only be financed by retained profits that have not been paid out to shareholders. It is not possible to convince lenders to advance the firm a loan to engage in CSR. This is because CSR is an investment in future profitability and may not yield returns in the short run. Therefore, FPL Group may need to reduce its dividend pay-out in order to finance projects aimed at CSR. It should be appreciated that shareholders may be willing to pay a premium for the environment.
Although a reduction in dividend pay-out in the short run may result in a reduction in the market price as the current shareholders sell their stock holding, in the long the share price and market value of FPL will stabilize. Research shows that there are two categories of investors depending on income level; low income investors and high income investors. Low income investors prefer firms that pay high dividends to supplement their earnings and meet their consumption needs. On the other hand, high income investors prefer capital gains to dividends as a tax management mechanism. The high dividend pay-out may have attracted low income earners who are keen on high dividends. Reducing the dividend pay-out will result in a shift in the investor type until the share price stabilizes when it reaches equilibrium. In the long run, FPL Group will attract investors who are not keen on high dividends but prospects of capital gain.
FPL Group can also choose to pay dividends using a bonus issue of stock. Shareholders may not feel the impact of the dividend cut because they will be considering the additional shares they have in the company. Shareholders can sell those shares in the secondary market if they need the money. It should be appreciated that selling shares will only attract capital gain tax which is lower than taxes on dividends. The company would have retained its earnings that would have been paid out to shareholders for investment in profitable projects. However, bonus dividends do not increase the wealth of shareholders since it merely capitalizes retained earnings.
Works Cited
Petty, J, et al. Financial Management, Principles and Applications. 6th edition. French Forest, NSW, Australia: Pearson Education, 2012.
