Lowest Dividend Payout Ratio and Capital Structure: CFA Level 1 Exam Answer

Lowest Dividend Payout Ratio

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Question

Which of the following firms would likely have the lowest dividend payout ratio? Further, the capital structure of this firm would likely be weighted more heavily with debt or equity? Choose the best answer.

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A. B. C. D. E.

A

Of the firms listed, the biotechnology company would be expected to have the lowest dividend payout ratio. The nascent biotechnology industry is characterized by a high degree of investment in research and development, along with a high growth rate and high level of uncertainty. All of these factors are conducive to a high retention rate, i.e. a low dividend payout ratio.

Further, firms within industries associated with high growth rates and high levels of uncertainty are likely to be financed primarily with equity. This is reasoned by several factors, some of which include the following:

Firms in new industries typically have a balance sheet weighted heavily toward intangible assets, which can neither be easily liquidated nor pledged as collateral for a loan.

Firms in new industries are characterized by a high degree of research and development expenses. Equity provides firms with a higher degree of agility than debt financing.

The cash flows of firms in developing industries are characterized by a high degree of uncertainty.

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