Question

Company management, especially in established corporations, will formulate a policy that is often called a distribution policy or a payout policy. This policy specifies what management intends to do with the company’s profits and any free cash flow (FCF) generated by the firm. The objective is to create a distribution policy that increases the value of the firm and maximizes the wealth of the firm’s shareholders.

Which of the following factors affects management’s decisions regarding a firm’s distribution policy? Check all that apply.

The level of retained earnings to maintain

The level of reinvestment in Treasury bills and bonds

The method of payment to shareholders—cash or stocks

The level of payout to shareholders that is sustainable in the future

Management can make any form of distribution to the firm’s shareholders using the company’s free cash flow (FCF). The underlying objective is to maximize shareholder wealth by increasing the firm’s value. Any use of FCF that negatively affects the firm’s value is not considered a good use of the FCF.

Which of the following uses is considered to be a good use of free cash flow? Select the better answer.

Invest in nonoperating assets

Invest in operating assets

Theoretically, there are some traditional ways of using FCF. If a company uses all of its FCF to pay off all of its debt, it would reap the maximum benefit from the tax-deductible component of interest payments toward the debt.

This statement is false because if the firm uses its FCF to pay off all of its debt, it would have     and no deductible.

Answer 1

Question 1

Option 1 & 3

The level of retained earnings to be maintained is an important factor as it is an important source of capital to the firm.

The payment in cash or stocks is important because payment in cash may affect company's liquidity while in stocks may affect the dilution of ownership.

Question 2

Option 1

Investing in non-operating assets with the free cash flow is a better option as it allows the firm to grow. Free cash flow is generated as a result of company's activities after accounting for all their expenses and liabilities. Thus it is better spent in non-operating assets activities such as Capex.

The operating activities can be better funded using a working capital loan or other similar methods.

Question 3

The statement is false because if the firm uses its FCF to pay all its debt it would have no interest obligations and all its earnings would be taxable.