Updated July 17, 2023
Definition of Reinvestment
Reinvestment is a phenomenon in which the return earned or received on the funds invested in the form of dividends or interest in case of debt or fixed interest securities are used for the purchase of additional units of that particular investment option. In other words, the return is plowed back into that particular investment option.
It is one of the very good methods companies use to increase the value of their stocks, shares, and other securities. The reinvestment happens when the investors avail the option of reinvesting their return on the investment instead of taking it as cash payouts. The reinvested amount uses to buy the additional units of that particular investment option.
Though on the outside, it would seem that reinvestment creates a win-win situation for the company and the investors, as on one side, the company’s stock value will significantly increase. On the other side, the investor’s number of shares will also increase. But in hindsight, investors are also exposed to reinvestment risk because investors would not be able to reinvest the interest or dividend at the rate equivalent to the current return. The risk is high with bond investments or fixed-interest securities.
Example
Let us take an example where a shareholder who owns 100 shares in the company at $10 per share gets a dividend of 5 per share, i.e., $500.The shareholder can decide to reinvest the dividend and buy the additional shares of the same company at the current market value of $10 per share, i.e., 50 additional shares.
| Particular | Value |
| Original no. of shares | 100 |
| Current MV of share | $10 per share |
| The total value of the shares | $1,000 |
| Investment at the market value | 50 shares |
Secondly, the shareholders can decide to keep the money to themselves.
Reinvestment Rate
The reinvestment rate is the rate at which the dividend, interest, or other income is reinvested or plowed back into the investment. It calculates the percentage of return that can earn on this investment, generally in the case of fixed-interest securities. The reinvestment rate is impacted by the reinvestment risk, which represents a risk that the investors would not be able to reinvest the funds received in the form of dividends or interest at the rate equivalent to their current investment.
There are several ways through which an investor can manage the reinvestment risk on the reinvestment rate. For example, investors can invest in non-callable securities in which the borrower cannot call off high-interest-rate investment when the market is down. They can buy zero-coupon bonds as they do not pay coupons and, thus, a reduced reinvestment risk.
Importance of Reinvestment
The importance can understand from the following points:
- Reinvestment in the business shows the company’s expansion plan for the future, as the reinvestment fund will help the industry find an additional revenue stream, which will ultimately help increase the profit.
- It is a source of saved funds for the business; they can use them to buy new assets, pay off their liabilities, or fund a new project.
- It also serves as a positive point for the existing and new investors because the reinvestment indicates that the company is on the growth path.
- From the shareholders’ perspective, it increases their number of shares or the percentage of ownership in the company.
Advantages
Below are some of the advantages:
- The business can use reinvestment funds for further growth and development.
- From the investors’ perspective, they can purchase additional units of the stocks without bearing additional costs associated with the investment.
- It serves as a source of funds for companies or businesses.
- It helps in increasing the value of the stock considerably.
Disadvantages
Below are some of the disadvantages:
- Reinvestment reduces diversification as the funds are reinvested in the same type of securities, increasing concentration and reducing portfolio variety.
- There is a reinvestment risk due to which investors might be unable to reinvest the dividend or interest at the rate equivalent to the previous rate.
- In a way, it reduces one source of income for investors, who would have received dividends or interest over their investment if reinvestment didn’t happen.
Conclusion
Reinvestment is a very important phenomenon; it is very beneficial for businesses because it serves as a source of funds for them and helps them pave the path of growth and development. For investors, it does help them in purchasing additional units without bearing additional brokerage fees, etc., but it also eliminates the source of income for them.
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