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

False

The free cash flow hypothesis, proposed by Michael Jensen, actually suggests that when corporations generate cash flows that cannot be reinvested in positive net present value (NPV) projects, these excess cash flows should not be retained within the firm. Instead, according to the hypothesis, these funds are better off being returned to the shareholders, for example, in the form of dividends or share buybacks. The rationale behind this is that retaining excess cash could lead to agency problems, where the management might invest in projects that do not maximize shareholder value or might simply misuse the funds.

The free cash flow hypothesis is skeptical of management's motives and efficiency in allocating excess cash. It suggests that in the absence of a worthwhile investment opportunity, excess cash should be distributed to shareholders to prevent inefficient use of resources by managers.