Firms in which of the following industries would likely have the highest earnings retention rates? Further, would firms within this industry likely be financed primarily through debt or equity?
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A. B. C. D. E. F.F
Firms in the pharmaceutical industry would likely retain a higher proportion of their earnings than automobile manufacturers or retail banks. This is reasoned primarily by two factors. First, pharmaceutical companies have high research and development costs, and their success depends largely on the discovery of promising drugs. This requires that adequate funds be held within the firm. Secondly, growth opportunities in the pharmaceuticals industry are much more abundant than in either the automobile manufacturing or retail banking, and this is largely due to the maturity of the industry as a whole.
Pharmaceutical companies typically have numerous positive NPV investment opportunities.
In terms of financing, pharmaceutical firms would be expected to have a capital structure weighted more heavily toward equity than debt. As the cash flows of an industry become more certain and stable, the level of debt financing should be expected to increase. Automobile manufacturers and retail banks have very predictable cash flows, along with high degrees of leverage. Certainty of revenues and earnings is a very important consideration in the financing decision, and firms whose cash flows are both stable and easily forecasted will likely prefer a high degree of debt versus equity financing. Another important note to consider is the fact that the balance sheet of a pharmaceutical firm is more heavily weighted toward intangible assets than is a retail bank or an automobile manufacturer.
Intangible assets cannot easily be pledged as collateral for a loan, neither can intangible assets be liquidated with any degree of certainty. A high proportion of intangible assets within the asset structure of a firm is conducive to a low degree of debt financing.