ACCA Advanced Financial Management (AFM) Practice Exam

What does the payout policy determine for a firm?

1. The overall market value

2. The level of dividends and retained earnings

3. The amount of debt to be issued

4. The investment opportunities available

The correct answer is: The level of dividends and retained earnings

The payout policy of a firm primarily determines the level of dividends that will be distributed to shareholders as well as the amount of earnings that will be retained within the company for reinvestment. This policy reflects the company's approach to balancing the distribution of profits to shareholders with the need to retain earnings for growth opportunities. By establishing its payout policy, a firm signals its financial health and future growth prospects to investors. A high payout ratio can indicate a mature company with stable earnings, while a lower ratio may suggest that the firm is reinvesting earnings to fund expansion or new projects, which can be interpreted as growth potential. Thus, the payout policy is critical because it influences both immediate shareholder returns through dividends and the long-term financial strategy of the firm by guiding how much profit is reinvested versus distributed. This approach to managing earnings impacts the overall financial strategy and investment opportunities available to the company, but the fundamental aspect it determines is indeed the level of dividends and retained earnings.