There are indeed certain tradeoffs with each mode of reducing cash holdings. Increased dividend payments indeed increases the public view of the stock, and keeps the shareholders happy, but it creates a precedent that will always be looked at in the future. For example, if a firm declares high dividends this year, and for the next five years cannot match that dividend declaration due to economic and financial problems, shareholders and analysts will state that the company is underperforming thus resulting in fewer profits and less dividends in comparison to the one declared this year.
Share buybacks are a good way of decreasing the equity of a firm, but by decreasing the size of a firm controlled by investor’s equity, puts more power into the control of management which may lead to less checks and balances with regard to corporate acts which normally would alarm a shareholder. Many firms have gone belly up because top management acted in ways that greatly prejudiced the firm despite the voiced out concerns of a minority of shareholders. Indeed, just as the logic underlying this paper is that a balance between cash and debt on a balance sheet is good, so too is a balance between management and shareholder equity in control of a firm. ...Show more