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Optimal Dividend Payout Ratios/Optimal Debt-to-Equity Ratios

1- U.S. public companies with "low" dividend payouts have payout ratios of less than 1 percent, firms with "medium" payouts have ratios between 1 and 48 percent, and "high" payout firms have a ratio of 49 percent or more. Given these data, how would you classify the following firms in terms of their optimal payout policy (high, medium, or low)?

Successful Pharmaceutical Company

Electric Utility

Manufacturer of Consumer Durables

Commercial Bank

Start-Up Software Company

2- U.S. public companies with "low" leverage have an interest-bearing net debt-to-equity ratio of 0 percent or less, firms with "medium" leverage have a ratio between 1 and 62 percent, and "high" leverage firms have a ratio of 63 percent or more. Given these data, how would you classify the following firms in terms of their optimal debt-to-equity ratio (high, medium, or low)?

Successful Pharmaceutical Company

Electric Utility

Manufacturer of Consumer Durables

Commercial Bank

Start-Up Software Company

Solution Preview

1- U.S. public companies with "low" dividend payouts have payout ratios of less than 1 percent, firms with "medium" payouts have ratios between 1 and 48 percent, and "high" payout firms have a ratio of 49 percent or more. Given these data, how would you classify the following firms in terms of their optimal payout policy (high, medium, or low)?

Successful Pharmaceutical Company

Electric Utility

Manufacturer of Consumer Durables

Commercial Bank

Start-Up Software Company

Answer:
Firm factors that may influence the dividend payout ratio include the stage in the life cycle, investment opportunities, external financing costs, access to funds and reserves, and the profitability and earnings stability. There is link between a firm's place in the life cycle and its dividend policy. Firms generally adopt dividend policies that best fit where they are currently in their life cycles. For instance, high-growth firms with great investment opportunities do not usually pay dividends, whereas stable firms with larger cash flows and fewer projects tend to pay more of their earnings out as dividends.
Interrelationships often exist among these factors. Firms tend to pay a high dividend payout if they: (1) are in the maturity and/or decline stage in their life cycle, (2) have low investment opportunities and external financing costs, (3) have a high access to funds and reserves, and (4) high profitability and stable earnings. On the other hand, conditions favoring no or smaller dividend payouts occur when firms: (1) are in the start up to rapid growth stage in their life cycle, (2) have high investment opportunities and external financing costs, (3) have a low access to funds and reserves, and (4) low profitability and unstable earnings.

Successful Pharmaceutical Company: Low
A successful pharmaceutical company has high expected growth rate and therefore would pay low dividends as it would plough back earnings into further investments.

Electric Utility: High
An electric utility has low expected growth rate and therefore does not have many investment opportunities. Therefore, the dividend payout is high.

Manufacturer of Consumer Durables: Medium
A manufacturer of consumer durables is in a mature industry; thus dividend payout would be high. But because the market is competitive there is variability in the cash flow. Since the firms wish to maintain a stable payout ratio, the variability in cash flow causes moderation in the amount of dividends paid out.

Commercial Bank: Medium
Because the interest rates fluctuate, the earnings of banks fluctuate. Since the firms would like to maintain a stable payout ratio, the payout ratio is medium.

Start-Up Software Company: Low
Young, rapidly growing firms often pay no dividends or have a low dividend payout ratio, while older, slower-growing firms in mature ...

Solution Summary

Classification of firms based on optimal payout policy and optimal debt-to-equity ratio.

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