The Effect of Buybacks on Capital Allocation

Abstract

This paper studies how the flexibility of share buybacks relative to dividends affects capital allocation, aggregate investment and welfare. I propose a dynamic equilibrium model of heterogeneous firms with agency frictions and adjustment costs to dividend payments.
The shareholders of each firm decide equity financing and payouts. The presence of buybacks allows shareholders to easily pay out cash flows and control managers’ available funds. Further, buybacks make stock price more sensitive to profits, which improves the ability of stock-based compensation to discipline managers. These two channels reduce capital and cash misallocation across and within firms. The model is matched to micro data on public firms and can help explain several observed corporate trends: the decline in investment rates, the increase in corporate financial assets and the increase in profitability of capital.

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

JEL Classification: D21, E44, G35