Question

Firm M is a mature company in a mature industry. Its annual net income and net cash flows are consistently high and stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new company in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is CORRECT?

a) Firm M probably has a lower target debt ratio than Firm N.
b) Firm M probably has a higher target dividend payout ratio than Firm N
c) If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
d) The two firms are equally likely to pay high dividends.
e) Firm N is likely to have a clientele of shareholders who want a consistent, stable dividend income.

Answer 1

Answer:

Option (b) is correct.

Let us see why the others are not correct.

(a). firm M probably has a lower target debt ratio than firm N.

A matured company always concentrates on the development of the shareholders whealth, and a consistent dividend pay out ratio. So obviously the company M would like to use high debt to increase the earning per share. So the first option is wrong.

(b)Firm M probably has a higher target dividend payout ratio than Firm N
. As we said in the first option, the share holders of the matured company expects a higher rate of dividends, and a consistent dividend than the new growing company (industry). So this is the correct option.

(c). If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
The increase in the corporate tax rate will not influence the matured company's capital structure (debt equity ratio), as it may not use additional debt, so it is not correct.

(d). The two firms are equally likely to pay high dividends.

The new company may pay a higher dividend in a particular period, but there will not be consistency in the dividend pay out ratio. But the matured company will pay high dividend consistently. so it is not correct.

(e). Firm N is likely to have a clientele of shareholders who want a consistent, stable dividend income.

It is absolutely wrong since the share holders of a new and growing company will not expect the consistency in dividend pay out ratio. so it is wrong.