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Companies, especially established corporations, set up a policy, which is often called a distribution policy or a payout policy. These policies specify what companies intend to do with their profits and the free cash flow (FCF). The objective is to create a distribution policy that increases the value of the firm and maximizes shareholder wealth. Which of the following help firms determine the actual implementation of their distribution policy? Check all that apply. 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 The level of retained earnings to maintain A firm can make any form of distribution to its shareholders using the free cash flow (FCF) that it generates. The underlying objective is to maximize shareholder wealth by increasing the firm's value. Any use of the FCF that has a negative impact on the firm's value is not considered a good use of the FCF. Which of the following is considered a good use of free cash flow? Choose the best 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 tax deductible expense. no interest payments no tax payments The residual distribution policy approach is based on the theory that a firm's optimal distribution policy is a function of the firm's target capital structure, the investment opportunities that the firm has, and the availability and cost of extemal capital. The firm makes distributions based on the residual earnings. Consider the following example: Smith and Jones Co. is expected to generate $200 million in net income over the next year. Smith and Jones Co.'s shareholders expect it to maintain its long-run dividend payout ratio of 25% of earnings. Equity 604 Debe If the firm wants to maintain its current capital structure of 60% debt and 40% equity, what budget it can support with this year's expected net income? the maximum capital Most firms have earnings that vary considerably from year to year and do not grow at a reliably constant pace. Furthermore, their required investment may change often. Does this mean that the residual distribution policy approach cant be of any help to most firms? No Yes If you were to graph afirm's earings, cash flows, and dividends over the past 20 years, which would you expect to be the most stable over time? Cash flow Earnings Dividends Ignoring possible tax effects and signalling costs, the total value of a firm's equity remains the same irrespective of how the firm distributes its residual earnings--dividends or stock repurchases. Each distribution method has certain advantages and disadvantages. Based on your understanding of dividends and stock repurchases, select the best terms to go with the statements. Select the best term to complete the sentence Repurchase stock Distribute dividends Excess cash or a desire to recapitalize usually leads management to 7722. False O Repurchases are more dependable than dividends because the investor wealth does not decrease after a repurchase, whereas the stock price decreases when dividends are distributed. This statement is ???? False Based on the company's earnings in a particular year, repurchases can be made on an ad hoc basis without sending any negative signals to investors. This statement is 7222 Additional stock Repurchases allow investors who need cash to convert their Investment in the company into 7777

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