Dividend policy and free cash flow

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 companys 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 firms shareholders.

Which of the following factors affects managements decisions regarding a firms distribution policy? Check all that apply.

The method of payment to shareholderscash or stocks

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

The level of retained earnings to maintain

The level of reinvestment in Treasury bills and bonds

Management can make any form of distribution to the firms shareholders using the companys free cash flow (FCF). The underlying objective is to maximize shareholder wealth by increasing the firms value. Any use of FCF that negatively affects the firms 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.

Issue new stock

Repurchase stock

A companys investment opportunities and operating plans determines its level of FCF that can be used to distribute dividends to repurchase stock. This process is pretty straight forward in most companies across industries.

This statement is false, because sometimes the dividend distribution policy determines if the company is likely to scale back their operating and growth plans to existing dividend policy.