Question

The relationship between the dividends, retained earnings and a firm's growth rate suggests that firms can increase their stock price by increasing its plowback ratio. However, in reality we do not observe firms do this. Moreover, over the past decade we have seen firms disgorging their cash in the form of share repurchases. Why do you think firms are not plowing back more money into their firms?

Answer 1

Firms are often engaged in distribution of dividend and not engaged in retention of their profits because various investors are highly satisfied when they are realising the dividend payments on their stock holdings and there has been a tendency to distribute the profit to the shareholders and mostly those companies are engaging into the payment of dividend who does not have that growth left in them so they will be trying to distribute the profit back to the shareholder in order to make them satisfied and increase the share price to some extent also and it will also represent that managers are caring for the interest of the shareholders.

Firms are also not ploughing back more money into organisation and they are insisting on paying off the dividend or engaging into share repurchases because share repurchases is a most prominent way of increasing the share price of the company because their purchases are often done at Higher price than the current market price and it would be lead to matching of the market price with the purchase price in the short term in an Efficient market so company will easily have that upper hand in increasing the shareholders value by announcement of this share repurchases at a higher valuation.

Hence, it can be said that company are not retaining cash but they are instead paying out at dividend and share repurchase because they believe that it can increase their value quickly and they will gain the required capital from the market at a lower rate of interest because they are often wanting to use debt capital which will be providing them with interest tax deduction.