Distributions to Shareholders:

Dividends and Repurchases

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Aprofitable company regularly faces three important questions. (1) How much of its

free cash flow should it pass on to shareholders? (2) Should it provide this cash to

stockholders by raising the dividend or by repurchasing stock? (3) Should it maintain a

stable, consistent payment policy, or should it let the payments vary as conditions

change?

In this chapter we will discuss the issues that affect a firm’s cash distribution pol-

icy. As we will see, most firms establish a policy that considers their forecasted cash

flows and forecasted capital expenditures, and then try to stick to it. The policy can be

changed, but this can cause problems because such changes inconvenience the firm’s

stockholders and send unintended signals, both of which have negative implications

for stock prices. Still, economic circumstances do change, and occasionally such

changes require firms to change their dividend policies.

One of the most striking examples of a dividend policy change occurred in May

1994, when FPL Group, a utility holding company whose primary subsidiary is Florida

Power & Light, announced a cut in its quarterly dividend from $0.62 per share to

$0.42. At the same time, FPL stated that it would buy back 10 million of its common

shares over the next three years to bolster its stock price.^1

Security analysts called the FPL decision a watershed event for the electric util-

ity industry. FPL saw that its circumstances were changing—its core electric business

was moving from a regulated monopoly environment to one of increasing competi-

tion, and the new environment required a stronger balance sheet and more financial

flexibility than was consistent with a 90 percent payout policy.

What did the market think about FPL’s dividend policy change? The company’s

stock price fell by 14 percent the day the announcement was made. In the past, hun-

dreds of dividend cuts followed by sharply lower earnings had conditioned investors

to expect the worst when a company reduces its dividend—this is the signaling effect,

which is discussed later in the chapter. However, over the next few months, as they un-

derstood FPL’s actions better, analysts began to praise the decision and to recom-

mend the stock. As a result, FPL’s stock outperformed the average utility and soon ex-

ceeded the preannouncement price.

(^1) For a complete discussion of the FPL decision, see Dennis Soter, Eugene Brigham, and Paul Evanson,
“The Dividend Cut Heard ’Round the World: The Case of FPL,” Journal of Applied Corporate Finance,
Spring 1996, 4–15. Also, note that stock repurchases are discussed in a later section of this chapter.

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