The Myth of Corporate Reinvestment
There is a myth that when a midsize or large corporation has more cash on hand, possibly as a result of higher profit, it increases investment or adds jobs.
Let me be clear: What caused a higher or lower level of cash on hand does affect rational firms’ decision-making. For example, an increase in demand both increases cash on hand and affects investment decisions. But if a firm has access to capital markets, then the amount of cash on hand, by itself, is irrelevant to the firm’s budgeting, investment, and job creation.
I’ll define the term “Investment” expansively to include any commitment to a cash outflow _expected to generate a larger cash inflow. Under this broad definition, the accrual of any expense or capital expenditure (together “Expenditures”) is an Investment, because a business accrues the Expenditure in order to realize a profit.
If a rational firm has access to capital markets, then the first step in selecting Expenditures is to identify all those that are expected to generate more than a required rate of return. If all
sufficiently good Expenditures cannot be funded with cash on hand, then the rational firm obtains necessary funds from markets for debt or equity.
There is an interesting consequence of this: Consider what happens if cash on hand increases by $1 million due to a one-time windfall of $1 million. The $1 million does not increase the amount of Expenditures because the selection of Expenditures is independent of the amount of cash on hand. The windfall either reduces the amount of funds the firm obtains from capital markets (e.g. debt markets) or it is eventually distributed to shareholders, either through a dividend or share buyback. In both cases, the sole effect is that shareholder wealth increases by $1 million.
The effect of a rational firm having more cash therefore depends on what its shareholders do with their additional wealth. For any corporation, this is impossible to know because a corporation can have an extremely large number of direct and indirect owners.
For example, if a large cigarette manufacturer gets more cash, that does not increase the likelihood that there will be more cigarettes or cigarette jobs. The only result is that the millions of people who are direct and indirect owners of the manufacturer will have slightly more wealth. These same people more-or-less are also the owners of the major health care, auto, and consumer goods companies. So whether a cigarette manufacturer or a consumer goods company receives an extra $1 million, the effect is roughly the same: the wealth of the same set of millions of people increases by $1 million in total.
Many people incorrectly believe…
- …that it is bad when wasteful or unethical corporations have more money because either that money is lost to society or bad outcomes are promoted.
- …that it is good when corporations have more money because jobs are created.
- …that it is surprising or wrong that the $1 million is used for share buybacks or dividends.
The only possible effect of the extra $1 million is that millions of shareholders get wealthier from dividends or buybacks.
Often, things that we expect will have a big impact have no perceptible or noteworthy impact. This is the nature of markets and the world.