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Summary of chapter 37 : Internal financing: reinvesting cash flow
 
  Internal financing by reinvestment of cash flow enjoys an excellent image: it reduces risk for the creditor and results in capital gains rather than more heavily taxed dividends for the shareholder. For managers, it is a resource they can mobilise without having to go to third parties; as such, it reduces the company’s risk and increases the value of their stock options.

For the same reason, though, systematic reinvestment of cash flow can be dangerous. It is not appealing from a financial standpoint if it allows the company to finance investments that bring in less than the rate of return required given their risk. To do so is to destroy value. If the penalty for value destruction is delayed, as it often is because companies that reinvest excessively are cut off from the capital markets, the eventual sanction is all the harsher.

The trap for the unwitting is that internal financing has no explicit cost, whereas its true cost, which is an opportunity cost, is quite real.

Reinvesting cash flow makes possible organic growth at a rate equal to the rate of return on equity multiplied by the earnings retention ratio (1 minus the payout ratio). With constant financial leverage and a constant rate of return on capital employed, the organic growth rate is the same as the growth rate of book equity and capital employed. Lastly, the rate of growth of earnings per share is equal to the marginal rate of return on book equity multiplied by the earnings retention ratio.

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