IN the simplest textbook model of financial markets, companies
pay cash dividends each year to their shareholders, who can then
invest this money where they expect it to have the highest
future return. Thus, each dollar flows to its most profitable
use. In reality, companies often retain earnings and invest them
internally rather than distribute profits to their shareholders.
Such behavior is generally considered detrimental for
shareholders since it forces them to reinvest in the same
company, whether they want to or not. Furthermore, these
retained earnings can seriously distort corporate investment
decisions. If a good investment arises that is too large to be
financed out of existing cash reserves, companies may pass it up
rather than try to raise money from financial markets. On the
flip side, internal investments that are not particularly
profitable may be financed just because there is a lot of cash
on hand. Why do companies retain earnings, if they reduce
shareholder choice and lead to investment dist