Firm M is a mature company in a mature industry. Its annual net income and net c

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

Explanation / Answer

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

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