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The industry is also characterized by high payout ratios. Data about the investor owned utilities in the Southeast United States reveal that the payout for most companies is higher than 70%. FPL has one of the highest payout ratios of 91%. FPL has also maintained an increasing dividend for the past 47 years - the third highest streak amongst all the publicly traded companies. Miller & Modigliani argues that the dividend payout policy should not matter for an individual. MM model would theorize that, ignoring the tax differences, a decrease in dividends would have no effect on the value of FPL. A decrease in dividends would be compensated by an added increase in the stock price of the company (capital gains) such that the total return remains the same. Thereby, an investor can create ‘home-made’ dividends by selling a portion of his shares.

MM model makes certain restrictive assumptions (such as no tax differences) and ignores many external factors. Many factors influence the dividend policy of a company. Two factors that are relevant to the case of FPL are clientele effect and signaling. There are certain investors who might prefer a high dividend payout ratio. Such investors might have invested in FPL since it has historically paid high dividends. This assertion is also supported by the case study where the shares of FPL are described as a substitute for treasury bonds. Therefore, a drop is dividend policy might not be welcomed by the clientele that prefer high payout stocks. Such investors might want to sell their shares because of low payout ratio, leading to a fall in stock prices. Similarly, dividend increases are meant to signal the competitive strength on the company. This is especially true for a company like FPL that has a 47-year streak of increasing dividend. If the company suddenly decides to make a dividend cut, investors might take it as a negative signal about the future performance of the company. The signaling argument hold some traction because it is reasonable for investors to believe that the company would not want to break its 47-year streak unless the dividend cut is a last resort measure that is absolutely necessary to maintain the profitability of the company.

There seems to be a strong presence of signaling and clientele effect in the utility industry. Historically, dividend cuts by companies have not been received well by investors. In two previous cases, stock prices fell by more than 20% following a cut in dividends. Interestingly, both the companies were financially healthy and the cut is dividends could not be fully attributed to worsening performance of the company. Therefore, it might not be desirable for a company to cut its dividend in the utility industry. FPL should not be looking to cut cut its dividend unless it is necessary.

It is important to evaluate the financial position of the company under different dividend scenarios. Ideally, the company should choose a dividend policy that provides them a balance between operational stability and maintaining the confidence of their investors. There are three possible scenarios under consideration for the forecasted five years from 1994 to 1998: an increase in dividends at an annual growth rate of 2%, a constant dividend policy, and a 20% dividend cut followed by an annual growth rate of 5%. The attached spreadsheet calculates the effects of each of these alternative scenarios.

The capital asset pricing model (CAPM) can be used to calculate the required return on equity. The risk-free rate is assumed to be equal to the long-term (30-year) treasury bond yield. The yield is around 7.3% in May 1994. The beta is mentioned as 0.6, while the equity risk premium is assumed to be 6%. This gives as the required return on equity of 10.9%. The projected dividends for the next five years are available under the two scenarios of constant dividend and a dividend cut. Therefore, the dividend discount model can be applied to calculate the growth rate of dividends that is expected to result in the current price of $32 for FPL. The attached spreadsheet details these calculations. If the dividends are cut by 20% in the next year, the dividends will need to grow at a rate of 5.2% forever in order to justify a price of $32. On the other hand, if the dividends are not decreased, the dividends will need to grow at 3.5% to justify a price of $32.