Question

Answer true or false to the following questions relating to the free cash flow hypothesis.

a. Companies with high operating earnings have high free cash flows.

b. Companies with large capital expenditures, relative to earnings, have low free cash flows.

c. Companies that commit to paying a large portion of their free cash flow as dividends do not need debt to add discipline.

d. The free cash flow hypothesis for borrowing money makes more sense for firms in which there is a separation of ownership and management.

e. Firms with high free cash flows are inefficiently run.

Answer 1

a]

False

High operating earnings may not automatically result in high free cash flows because the capital expenditure and changes in working capital may be high, which could result in low free cash flows.

b]

True

Free cash flow = earnings + non-cash expenses - capex - changes in working capital

Large amounts of capital expenditure would result in lower free cash flows

c]

False

Debt is a cheap source of capital relative to equity. Using some amount of debt can lower the overall cost of capital for the firm, and provide leveraged returns to equity investors

d]

False

The free cash flow hypothesis for borrowing money makes sense for both types of firms, with and without separation.

e]

False

High free cash flows are generally indicative of efficiently run firms. However, this is indicative and not absolute. But it is wrong to conclude that they are inefficiently run