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According to Jensen’s free cash flow hypothesis, a company’s shareholders could decrease agency costs by demanding that management pay out all free cash flow as dividends. Such a solution would most likely appear in which type of company?
- A. Large-cap value stock.
- B. Large-cap growth stock.
- C. Small-cap growth stock.
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The correct answer is Option A.
In general, it makes sense for small or growing companies in industries characterized by a rapid change to hold cash and pay low or no dividends but it does not make sense for large, mature companies in relatively non-cyclical industries. Growth stocks need to reinvest in growth, whereas value stocks tend to generate strong free cash flow and have significantly fewer investment options.
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