Corporate Finance Analysis: Free Cash Flow and Investment Strategies

This report provides an analysis of corporate finance, focusing on how firms utilize their free cash flow. It explores the options of retaining cash for investments or increasing reserves versus providing payouts to shareholders through dividends or share repurchases. The paper discusses targeted repurchases, the importance of dividends, and the 'dividend puzzle.' It also examines tax preferences for share repurchases, the benefits of retaining cash for investment, and the reasons behind firms cutting dividends. The analysis highlights the advantages and disadvantages of each financial decision, considering their impact on stock prices and shareholder value, and references several key academic sources.

Running head: CORPORATE FINANACE ANALYSIS 1
CORPORATE FINANCE ANALYSIS
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CORPORATE FINANCE ANALYSIS 2
Corporate finance involves how a firm uses its free cash flow. It can retain it, or give
payout to shareholders. If the firm decides to retain the free cash flow, it can invest in new
projects or increase its cash reserves. However, if it decides to provide payouts, it can pay
shareholders in terms of dividends or repurchase the shares. Therefore, this paper provides
analysis of the concept of corporate finance.
1. Targeted repurchase is process in which a firm purchases shares directly from a
shareholder.
2. It is important for a firm to pay dividends instead of repurchasing shares because
when a dividend is paid, the prices of the shares start to drop in a fair capital market.
This happens when ex-dividend begins to be traded by the stock (Demarzo, 2013).
However, when a firm repurchase shares in a fair capital market, there is no effect on
the price of the stock. Therefore, it can signal to investors that the firm is not making
progress and drive them away.
3. The ‘dividend puzzle’ is a concept which entails rewards to firms paying dividends by
investors. Some theorists believe that dividends should not be used by firms as
incentives to trigger purchase of stock by investors. People who hold this opinion
believe that the funds used to pay dividends should be invested in a company’s
growth through re-investing the earnings through acquiring assets, starting a new
project, or repurchasing shares (Schneider, 2017).
4. Investors would have tax preference for share repurchases instead of dividends
because share repurchases provide an effective way to return capital to parties that
have invested in the company (Demarzo, 2013). This is because shareholders do not
incur additional tax on repurchases even though there is an increase in pro-rata equity.
Consequently, there is an increase in shareholders’ profits even if the overall profits or

CORPORATE FINANCE ANALYSIS 3
sales do not increase. However, dividends sometimes cause shareholders to receive
less than what they had invested (Jones, 2018). This is because shareholders are
required by law to pay taxes on They are also required to pay taxes on capital gains
the received dividends (Zingales, 2017). Additionally, when capital gains are taxed at
a lower rate than dividends, a firm gives shareholders money received from issuing
shares. Meaning, eventually, shareholders receive less than their investment.
5. Retaining cash enables a firm to invest in new projects. Also, it enables the firm to
increase its cash reserves (Kamin, 2017). However, if the capital market is not fair, it
sells dividends to retain cash.
6. Firms cut dividends when they perceive a long-term decrease in the level of expected
future earnings. Also, when there is a change in managers; views regarding the future
prospects of a firm’s earnings (Demarzo, 2013). In this case, the firm’s dividend
choice will lack information regarding the expectation of the management in future
earnings. Further, when a firm reduces its dividend, it is an indication that the
management has lost hope in the future prospects of the company in terms of
earnings. Consequently, it saves cash through reducing dividends.
In conclusion, this paper provided an analysis of how corporate uses free cash flow. A
company can either retain its cash flow or give it as a payout to shareholders. Both
alternatives have advantages and disadvantages to the company, stock prices, and
shareholders.

CORPORATE FINANCE ANALYSIS 4
References
Demarzo, J. B. (2013). Corporate Finance. Pearson.
Jones, C. S. (2018). Corporate financial accounting. Cengage Learning.
Kamin, J. W. (2017). Corporate Buybacks and Capital Investment: An International
Perspective. Board of Governors of the Federal Reserve System (US).
Schneider, U. (2017). Equity Capital Market Expectations of Corporate Issuers: The
Fresenius Perspective. In Equity Markets in Transition (pp. 487-489). Cham:
Springer.
Zingales, R. V. (2017). Corporate Finance. Journal of Political Economy. Journal of Political
Economy, 1805-1812.