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CA Final · Advanced Financial Management · Financial Policy and Corporate Strategy

Under the strategic decision making framework, a company's board finds that its return on invested capital consistently exceeds WACC and growth opportunities are available, but it pays out most earnings as dividends and then raises costly external equity. Which change in financial policy is most consistent with wealth maximisation?

The firm should retain more earnings to finance its positive-NPV growth opportunities, since returns exceed the cost of capital. This avoids costly external equity issues and increases shareholder wealth, whereas higher payouts or rejecting projects would reduce value.

  1. ARetain more earnings to fund the positive-NPV opportunities and reduce external equity issuanceCorrect
  2. BIncrease the dividend payout further to signal strength
  3. CReject all growth opportunities to preserve the payout
  4. DReplace all equity with short-term debt regardless of risk

Explanation

When returns exceed the cost of capital, retained earnings invested in positive-NPV projects add value and avoid issue costs. Raising payout while issuing equity is circular and costly; rejecting growth forgoes value; all short-term debt raises risk without a justification.

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