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• shikhagupta3288

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Question. What will Broadhead do regarding dividends? Option A- Broadhead should reduce the dividends. Following are the reasons for a reduced dividend policy. 1) Reduced dividend policy would help in saving investor’s money as dividends are taxed more than capital gains in terms of the extra amount of taxes paid. 2) Reduced dividend policy will result in extra cash which the company can use for future growth. This will address the issue of low capacity margin (8.6% against much higher industry average). The extra cash can also be used to repurchase its stocks. This will help in increasing its stock price. On a softer aspect, extra shares can be used as ESOP for increasing employee motivation. 3) According to Miller-Modigliani theory, dividend policy should not matter since the returns that investors would earn would be the same as the firm would receive if the cash were reinvested. 4) Additionally, FPL’s dividend policy is much higher than the industry average. Reducing dividend policy is concurrent with Broadhead’s vision of growth. 5) Reducing dividend does not affect majority of the shareholders (51.9% individual shareholders). Return on equity= Net Income/ Equity= 428749/ 4100607= 0.105 Cost of equity= rf + beta*(rm-rf) = 0.073 + 0.6* 0.008= 0.0778 As cost of equity < return on equity, the shareholders should buy the stock.

Question. 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 T-bonds 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 + β (RM - Rf) β = 0.60 (RM - Rf) = 7.5% Rf = 7.3% i = Rf + β (RM - Rf) = 7.3% + 0.60 * 7.5% = 7.3% + 4.5%= 11.8%

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% Question. From an investor’s perspective, is the FPL’s payout ratio appropriate? Explain and justify your answer based on information in the case. The payout by FPL is appropriate. FPL announced 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 $43.75 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 post-announcement 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 as being 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.

Question. As Kate Stark, what would you recommend regarding investment in FPL’s stock – buy, sell, or hold? FPL lowered its dividend from $2.48 to $1.68. The stock price initially took a big hit (down from $35 in April-94 to ~$30 in May 94). However it had recovered strongly by the end of the year and in May-95 was trading at $39. It went on to trade at $45 in May-96.

FPL maintained a lower dividend policy. The dividends increased by $0.08 each year after 1994.

If we look at the Net Incomes and Interest Amounts from 94-96, an interesting trend is revealed: 1994

1995

1996

Net Income

519

553

579

Interest Expense

319

291

266

Additionally, there were some share repurchases in 1996-97. What this suggests is that FPL is moving away from giving out dividends and then simply issuing more equity.

However, for future growth, it would be best that the company cut dividends by the theorized 30%. By doing this, share prices would drop as the market would react negatively in regards to the reduction, allowing the company to repurchase a substantial amount of their outstanding shares at lower prices. Following this, the proposed savings of over $150 million every year would allow for FPL to repay its debt, giving it greater financial flexibility, and allowing for more free cash flow. Despite this, the previously stated possibilities are just that – possibilities. Therefore, since FPL remains at a stable financial position, and Stark still believes that FPL will retain their dividends at $2.48, there is no reason for anything but a Hold recommendation until there are confirmed reports of dividends being cut.