Definition of Reinvestment
Reinvestment is a phenomenon in which the return earned or received on the funds invested in the form of dividend 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 in that particular investment option.
Reinvestment is one of the very good methods used by companies 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 in the form of the cash pay-outs. The reinvested amount is used 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 as well as the investors, as at one side the company’s stock value will significantly increase and on the other side the investor’s number of shares will also increase. But in the 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 the bond investments or fixed interest securities.
Let us take an example where a shareholder who owned 100 shares in the company at $10 per share got the 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.
|Original no. of shares||100|
|Current MV of share||$10 per share|
|Total value of shares||$1,000|
|Investment at the market value||50 shares|
Secondly, the shareholders can decide to keep the money with themselves.
The reinvestment rate is the rate at which the dividend, interest or other income is reinvested or plowed back in the investment. It is calculated in terms of the percentage of return that can be earned on the reinvestment generally in 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 dividend or interest at the rate equivalent to their current investment.
There are several ways through which an investor can manage the reinvestment risk on reinvestment rate. For example, investors can invest in non-callable securities in which the borrower is not allowed to call off high-interest rate investment when the market is down or they can buy zero-coupon bonds as they do not pay coupons and thus, a reduced reinvestment risk.
Importance of Reinvestment
The importance can be understood from the below points:
- Reinvestment in the business shows the company’s expansion plan in the future, as the reinvestment fund will help the business to find the additional revenue stream, which will ultimately help in increasing the profit.
- It is a source of saved funds for the business, they can use these funds to buy new assets, pay off their liabilities, or fund some kind of new projects.
- It also serves as a positive point for the existing as well as 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 in other words percentage of ownership in the company.
Some of the advantages are given below:
- Reinvestment funds can be used by the business for further growth and development of the business.
- From the investors’ perspective, they can purchase additional units of the stocks without having to bear additional costs associated with the investment.
- It serves as a source of funds for the companies or businesses.
- It helps in increasing the value of the stock considerably.
Some of the disadvantages are given below:
- Reinvestment leads to a reduction of diversification in the investment portfolio of the investor as the fund will be reinvested in the same type of securities.
- There is a risk of reinvestment due to which investor 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.
Reinvestment is a very important phenomenon; it is very beneficial for businesses because it serves as a source of fund for them and helps them in paving the path of growth and development for themselves. For investors, it does help them in purchasing additional units without bearing additional brokerage fees, etc. but it also does eliminate the source of income for them.
This is a guide to Reinvestment. Here we also discuss the definition and importance along with advantages and disadvantages. You may also have a look at the following articles to learn more –