For firms with free cash flows,

Question

Quizplus · Accepted Answer

With free cash flows, managers have the option to use those funds for personal or unnecessary expenditures. By taking on debt, managers are bound to use the free cash flows to make interest payments and pay off the principal. This is a strong mechanism for credibly bonding managers to release cash flows to investors. Equity dividends and preferred stock dividends are not as strong of a mechanism as debt because managers can choose to cut or reduce dividend payments without financial consequences.

For Firms with Free Cash Flows