The Effect of Buybacks on Capital Allocation

Abstract

This paper studies the macroeconomic effects of a 1982 SEC rule that made share buybacks a viable alternative to dividends for paying out funds to shareholders. I propose a quantitative model of heterogeneous firms with dividend adjustment costs and a manager-shareholder conflict, matched to micro data on US corporations’ cash flow statements. The flexibility of buybacks reduces capital misallocation. This is not only because investors can more easily shift resources to more productive firms, but also because stock prices become more responsive to productivity and thus help align incentives of managers and shareholders. This "stock price channel" allows the model to not only account for a decline in investment and increase in productivity, but also the increase in corporate cash holdings over the last decades.

Keywords: Payout Policy, Capital Reallocation, Investment, Cash Holding, Share Repurchases, Agency Frictions

JEL Classification: D21, E44, G35