Question

According to the free cash flow hypothesis that has been proposed to explain how dividend policies affect stock prices, cash flows that cannot be reinvested in positive net present value projects should be retained and reinvested by the firm. a. True b. False

Answer 1

b. False

Step-by-step explanation:

As per free cash flows hypothesis, a firm after exhausting viable favorable investment opportunities starts investing in non viable projects with negative net present value which yield losses.

Thus, for a firm which has already exhausted it's favorable investment opportunities is still left with excess cash, rather than investing into non favorable projects, it would be better for the firm to distribute such amount to it's shareholders as dividends.

Since profits and losses from investment projects ultimately belongs to owners and shareholders, investment in loss making projects cannot maximize shareholders wealth.

Thus, as per the policy, a firm should distribute surplus cash left after investing into favorable projects, to it's shareholders as dividends and not retain such surplus.