Question

2. A firm ‘Kappa Industries’ is a very young business, which is growing rapidly and to which intangible assets are very important. In contrast, another firm ‘Gorgeous Food’, whose business is profitable and stable, but has limited growth opportunities and most of its
assets are tangible. With this setup, answer the following questions.

a) Assuming that the predictions of the pecking order theory hold, which firm should have a higher payout ratio? Explain concisely why.

b) Assuming that the predictions of the trade-off theory hold, which firm should have a
higher debt-equity ratio? Explain concisely why.

Answer 1

Before answering the question, let's understand conceptually the state of the two companies and their likely course of action:

Kappa Industries

• The firm is young in business. This implies:
  • The cash flows being generated will be lower, volatile and unstable.
  • Since cash flows are volatile, the situation is not appropriate enough to go for debt as external source of capital as it requires periodic, regular and mandatory servicing.
  • Hence the firm should preserve its capital and hence should follow a near zero dividend payout policy.
• The firm is in rapid growth phase. This implies:
  • It must be coming across many new investment opportunities
  • The new investment opportunities should be offering a return on equity in excess of cost of capital (that's why the company is in high growth phase).
  • The company will be in need of significant external financing.But since it has and will have mostly intangible assets and cash flows which are low and volatile, it will find it very difficult to aise external debt funding.
  • Hence the firm should preserve its capital and hence should follow a near zero dividend payout policy.

Gorgeous Food

• Business is profitable and stable
  • The firm is in a situation where it can sustain a higher proportion of debt in a capital structure and service the same regularly, periodically and mandatorily through its stable cash flows
• It has mostly tangible assets
  • This implies the firm can offer hard security and collateral to lenders. Thus it will have high debt capacity
  • It is further expected to have lower cost of distress as it has tangible assets as security. It can thus sustain relatively higher debt.
• The firm has limited growth opportunities
  • And such opportunities will have ROE lower than the cost of capital
  • In such a case, the firm is better off returning money to the shareholders by following a very high dividend payout policy.

Based on these understanding, let's now approach the problem.

Part (a)

Which firm should have a higher payout ratio? Explain concisely why.

Based on our arguments above, Gorgeous Food is in a stage where it make sense for it to return money to the shareholders rather than invest in growth opportunities where return on equity is lower than the cost of capital. Thus, Gorgeous Food should have a higher payout ratio.

Part (b)

Which firm should have a higher debt-equity ratio? Explain concisely why.

Based on our arguments above, Gorgeous Food is in a stage where it can sustain and service a relatively higher proportion of debt in its capital structure. The debt capacity will also be higher as it's assets are mostly tangible. Thus, Gorgeous Food should have higher debt to equity ratio.