Dividend Policy at FPL Group, Inc.

Question 1 Major Sources and Uses of Funds Sources: Operating cash flows, debt issuance, stock issuance Uses: Capital expenditure, dividends, retirement of debt and preferred stock
Sources of Funds (in millions) Operating cash flow Debt +toc) iss'ance ,O,-# Percentages Operating cash flow Debt +toc) iss'ance !ses of Funds (apital expen$it'res Di/i$en$s 0etire1ent of $ebt an$ pref stoc) ,O,-# Percentages (apital expen$it'res Di/i$en$s 0etire1ent of $ebt an$ pref stoc) +o'rces less 2ses Other net inflows o'tflows* 1993 1,267 2,399 276 3,942 32. 61. 7. 1992 988 1,025 422 2,435 41. 42. 17. 1991 1,194 265 318 1,777 67. 15. 18. 1990 1,053 276 796 2,125 50. 13. 37. 1989 963 exh 5 214 exh 5 !"# bon$s % !"# &ro'p (apital % pref stoc)* 73 exh 5 1,250 Simple average 77. 53% 17. 30% 6. 1 %

1,248 462 2,648 4,358 29. 11. 61. 416* 490

1,391 431 670 2,492 56. 17. 27. 57* 35*

1,344 392 360 2,096 64. 19. 17. 319* 275

1,039 324 142 1,505 69. 22. 9. 620 428*

836 exh 5 298 exh 5 194 exh 5 1,328 Simple average 63. 5"% 22. 18% 15. 2"% 78* calc'late$ ,O,-# +o'rces 3 ,O,-# 2ses* 23 (alc'late$ pl'g4 incl'$es $i/estit'res, cash fro1

Discontin'e$ ops, receipts fro1 parterships an$ leases, n'clear f'el sale, change in notes pa5ables, other6 exh 5

7et increase $ecrease* in cash

74

92*

44*

192

55*

Industry Structure The industry is in the early stages of transformation from one characteri ed by local and regional regulated monopolies !with regulated rates, returns, and capacity planning" to an open and competitive deregulated landscape# The emergence of $retail wheeling% !the ability of customers to purchase electricity from utilities other than the local monopoly" is expected to increase the level of competition# This encourages the development of new energy technologies and a focus on customer service# &ssets must be managed in an aggressive and active manner as opposed to the passive, custodial approach taken throughout the years of regulated monopolies# Competitors are focused on increasing revenues, cutting costs, and sei ing market share# US electric power industry value chain includes generation, transmission and distribution !'x# ("# )ote that even under deregulation, there would be a single transmission system and a

single distribution system in each market !the public utility*s", but competing generators would be granted access to these systems# +istory of deregulation: (,-. / 0eregulated generation: 1U21&, or 1ublic Utilities 2egulatory 1olicies &ct, re3uired utilities to purchase the entire output of generators using renewable or non4traditional fuels !wind, solar, etc#" (,,5 / 0eregulated transmission: )'1&, or )ational 'nergy 1olicy &ct, re3uired utilities to open their transmission systems to utilities in other territories at the same 3uality and cost# 0isputes broke out over access fees and rights !e#g#, 617 in lawsuit over excessive rate charging for access to its transmission lines !89: of 6lorida transmission lines owned by 617""# There is a general concern whether there would be sufficient transmission capacity in the future# (,,; / 0eregulated distribution: C& experimenting with retail wheeling: customers can buy electricity from sources other than monopoly supplier beginning in (,,<# There is considerable uncertainty as to the timing, extent, and effect of retail wheeling on the 6lorida power market# 617 is the largest utility in 6lorida and the ;th largest in country, with a service area of <#8 million people !=#; million customer accounts" that includes < of nation*s (9 fastest growing metropolitan areas# ey !usiness "is#s Competition !in generation and in distribution" from new and existing players due to deregulation# 1otential loss of business and price pressures# Capacity: Can 617 generate enough electricity to meet increasing demand> ?ill new line additions provide sufficient transmission capacity thorough 5995 as predicted> 2ising interest rates: (;9 bps since September (,,=# 0ebt rating by S@1 now includes evaluation of competitive position !growth prospects, revenue vulnerabilities and dependencies, rates, capacity, fuel diversity, regulatory environment, etc#"# & deterioration of competitive position will lead to a lower credit rating, increasing cost of funds and insolvency risk# Uncertainty around how deregulation will happen / for example, will 617 be forced to sell off its generating capacity !like 1A@'">

Question $ FPL%s Strate&y Until the (,-9*s, steady growth# Then, rising fuel costs, construction cost over4runs, and operating problems !power outages leading to customer service issues" reduced profitability# (,.9s: 0iversified into higher growth businesses to increase profits through ac3uisitions / insurance !Colonial 1enn", cable !Telesat", information services !CB2", citrus !Turner 6oods !B&0 ideaC"" / and through subsidiaries !&landco for real estate development and 'SD 'nergy for alternative energy development"#

&lso launched a rigorous 3uality control program !downtime from (.: to ;:, complaints down <9:E received 0eming 1ri e in (,., and were considered $one of the best managed US corporations%"# (,., / Fames Broadhead succeeds Gc0onald# Dndustry outsider !from telecom" with vision of future as one of full and open competition# Goves toward long4range strategic plan, which identifies the need to focus on core business, to maintain commitment to 3uality and customer service, to expand capacity, and to improve costs# 0ivest non4core businesses !Colonial 1enn sold, trying to sell Telesat and &landco"# 'xpand capacity / huge cap ex for both transmission and generation !H<#<B over 8 years"# Scale back 3uality program while reducing costs and increasing efficiency !eliminated ;,999 positions over 5 years, lowered operating and maintenance expense from (#.(c per k?h to (#<(c#

Future of FPL Uncertain competitive landscape, with retail wheeling looming# 0oing relatively well in preparing for deregulation !including Broadhead as C'O, who headed AT' during phone deregulation"# S@1 rated 617*s business position in the top (9: of investor4owned utilities across the US# Arowth higher than national average !=#;: vs 5#9: over past 8 years, expected at 5#-: vs (#.:"# Covers < of (9 fastest4growing markets in country !exh 5"# Capital expenditure decreasing by ==: to H=#,B over the next five years# Currently has higher percent of power purchased !=9:" compared to other utilities at about (8: !ex -"# This indicates that large investment in cap ex was a good decision / prepares for future increased demand and reduces dependency on open market purchases !though, case doesn*t indicate if =9: is already an improvement or if that : went down in (,,; when new capacity came on4line"# Overall, 617 has taken successful steps to prepare for deregulation and competes in a relatively attractive geographical marketplace# &lthough the uncertainties surrounding deregulation make it difficult to predict the company*s fate, it is better positioned than most of its peers to tackle the challenges# Question '( Does FPL%s dividend policy )a#e sense* +istorical dividend policy: Steadily increasing dollar amount for ;- years# Currently paying out approximately ,9: of earnings as dividends# 6or a regulated industry, this policy makes sense / because cash flow is stable, investors in this industry are looking for stability in yields, not growth# +owever, due to tax implications, dividends are usually more valued by institutional investors than individuals !the latter paying lower tax on capital gains than on dividends"# &ccording to exhibit (9, 617 ownership is 85: individuals, =-: institutions, and ((: other# This would

imply that there is a mismatch between the desires of the maIority of the investors and the policy# 0ue to the increased tax wedge !Capital Aains Tax J 0ividend Tax" after (,,= tax law changes, the yield tilt would exacerbate and could result in a higher expected before4tax return# 2ationally, individual investors should prefer earnings retention !assuming investment opportunities that earn above cost of capital", but behavioral reasons !dividends resolve uncertainty" probably dominate the mainly individual investor base# Thus, investors would expect a steady stream of increasing dividendsE this lends support to the current dividend policy# One aspect of 617*s dividend policy that is 3uestionable is their issuance of stock at the same time they are paying dividends# The table below shows that in (,,( and (,,5, most of the dividend payments were offset by the issuance of new stock# Thus the net cash to shareholders over the 84year period is actually very small#
$ividends paid %ommon stoc& issued 'et cas( to s(are(olders 1993 1992 1991 1990 1989 #otal 462 431 392 324 298 1907 276 423 318 796 73 1886 186 8 74 3472 225 21

Question +( Si&nalin& I)plications Dividend ,ut Typically signals that the company is doing poorly, perhaps indicating that the company knows there are significant risks to future C6s due to deregulation# 'ven if the market does not perceive a negative signal, cutting dividends would likely cause near4term price volatility as investors who invested for dividends as opposed to growth switch out of the stock# Other potential argument is that the company believes future investment opportunities !possibly due to deregulation" could provide returns in excess of re3uired returns on the e3uity, and that it is cheaper to finance these opportunities internally !in light of recent interest rate increases"# &lso, cutting dividends today could allow 617 to show large dividend increase in future years assuming continued C6 growth# Maintainin& Dividend &nything other than a dollar amount increase is probably a negative signal given history# Breaking the precedent set over the past ;- years of raising dividends sends a negative signal, although the magnitude of that signal for a cut is greater than for a non4increase# Usually dividend yields are about ;48: !ex# -" but due to interest rate increases in early (,,;, they are currently <4.: !ex# (9"# 617 is in line with industry on yield, but high on payout ratio# Df management*s purpose is to lower the payout ratio in order to retain funds for profitable investment, maintaining dividends instead of cutting them could signal confidence in future growth# !& dividend cut would suggest that earnings will not grow sufficiently fast to reach the targeted payout ratio when needed#" Merrill Lync-

G7 believes that 617 may undertake a serious review of its dividend policy !because its payout ratio is too high given the increasing risks facing the industry", but seems to expect that 617 will grow out of the high payout instead of cutting the dividend# Dn sum, for the dividend policy signal to be credible, there must be asymmetric info between management and investors !i#e# management knows something investors do not"# )egatively, this could be that management is uncertain about future C6*s# 1ositively, it could mean management has identified investment opportunities that it intends to finance internally, and possibly that management has optimistic expectation of future C6*s and intends to grow out of the high payout ratio# .ssessin& t-e credi/ility of t-e si&nal The table below provides four possible explanations for the dividend cut, and the evidence supporting it and refuting it# 2eason for Cut 6uture cash flows are uncertain Supporting &rguments 0eregulation taking place: demand and price pressures Gay be difficult to meet demand in future )ew comp system based on net income / try to pay down debt so that interest costs are lower Aiving $bad news% makes stock cheaper at time of granting Arowing demand for electricity in 6lorida, coupled with deregulation 2efuting &rguments Since 617 owns generating assets, it is positioned to benefit from deregulation &bove4average revenue growth expected !ex <" Board and analysts would catch on 3uickly and perhaps try to punish management

Ganipulate new compensation system

)eed additional cash for investing in capex

Stop playing games with stock issuance

Dt is costly to pay dividends and then issue more e3uity

Gost of capex appears to have been completed over past few years 'x# < proIects a slowdown in capex ?hy risk backlash, and not continue using debt> Shareholders haven*t complained up till now, so why change>

Aiven the arguments outlined above the credibility of reason ( is 3uestionable# Dt is possible that the actions are being conducted for reasons 5 and ;# The 1ostscript provides some evidence to suggest that this may be true#

Question 0( Invest)ent "eco))endation )ear term / hold# 0ue to deregulation, there will be some short4term fluctuations in stock valuation, especially if there is a dividend policy change, which will cause some investor shakeup# 7ong term / buy# Because 617 is well positioned to take advantage of deregulation / even though competition will increase, 617 has Iust increased capex and will be able to supply the increased demand# )eed to understand the investor base better, as well as management intentions# '3uity investors should not want continued dividends for the reasons mentioned previously, but behavioral implications probably pervade#

Postscript 617 lowered its dividend from H5#;. to H(#<.# The stock price initially took a big hit !down from H=8 in &pril4,; to KH=9 in Gay ,;"# +owever it had recovered strongly by the end of the year and in Gay4,8 was trading at H=,# Dt went on to trade at H;8 in Gay4,<# 617 maintained a lower dividend policy# The dividends increased by H9#9. each year after (,,;# Df we look at the )et Dncomes and Dnterest &mounts from ,;4,<, an interesting trend is revealed:
'et *ncome *nterest +,pense 199) 519 319 1995 553 291 199" 579 266

The increase in )et Dncome from (,,; / (,,< is almost entirely attributable to lower interest charges# This is consistent with them paying down their debt from H=#,m to H=#(m during the same period# This evidence tends to support the compensation argument outlined above# &dditionally, there were some share repurchases in (,,<4,-# ?hat this suggests is that 617 is moving away from giving out dividends and then simply issuing more e3uity#