Answer: debt reduces management opportunities to misuse cash.

**Explanation:** Jensen's free cash flow hypothesis is a corporate finance theory that addresses agency problems between managers and shareholders. The key points are: 1. **Free cash flow** refers to cash flow in excess of what is required to fund all projects with positive net present value (NPV). 2. **Agency problem**: Managers may misuse free cash flow by investing in negative NPV projects (empire building), making value-destroying acquisitions, or spending on perquisites rather than returning cash to shareholders. 3. **Debt as a disciplining mechanism**: By taking on debt, companies commit to making regular interest payments, which reduces the amount of free cash flow available to managers for wasteful spending. 4. **Option B correctly captures this**: Debt reduces management opportunities to misuse cash by forcing them to use cash for debt service rather than discretionary spending. **Why the other options are incorrect:** - **Option A**: Internal financing is NOT preferable according to Jensen's hypothesis. In fact, Jensen argues that debt financing is preferable because it disciplines managers. - **Option C**: While debt issuance might signal confidence in some contexts, this is not the core of Jensen's free cash flow hypothesis. The signaling theory of debt (Ross, 1977) addresses this, but Jensen's hypothesis focuses on agency costs and managerial discipline. **Key takeaway**: Jensen's free cash flow hypothesis suggests that debt acts as a disciplining device that reduces agency costs by limiting managers' ability to waste free cash flow on value-destroying projects.

Author: LeetQuiz .