or otherwise increase value. If a firm repurchases its shares, it reduces
the number of shares outstanding and thus increases future per share
earnings. Finally, retained earnings can be used to expand the capital
of the firm in order generate higher future revenues and/or reduce
costs.
Some people believe that shareholders value cash dividends the
most, and that assertion is probably true in a tax-free world. But from a
tax standpoint, share repurchases are superior to dividends. As dis-
cussed in Chapter 5, share repurchases generate capital gains whose tax
can be deferred until the shares are sold. Recently an increasing number
of firms have been engaging in share repurchases. Nevertheless, the
commitment to pay a cash dividend often focuses management on de-
livering profits to shareholders and reduces the probability that earnings
will be spent in a less productive way.
Others might argue that debt repayment lowers shareholder value
because the interest saved on the debt retired is generally less than the
rate of return earned on equity capital. They might also claim that by re-
tiring debt, they lose the ability to deduct the interest paid as an expense
(the interest tax shield).^6 But debt entails a fixed commitment that must
be met in good or bad times, and, as such, the use of debt increases the
volatility of earnings. Reducing debt therefore lowers the volatility of fu-
ture earnings and may not diminish shareholder value.^7
Some investors claim the investment of earnings is an important
source of value. But this is not always the case. If retained earnings are
reinvested profitably, value will surely be created. But retained earn-
ings, especially if they are accumulated in liquid investments, might
tempt managers to overbid to acquire other firms or to spend these
funds on perquisites and other activities that do not increase the value
to shareholders. Therefore, the market often views the buildup of cash
reserves and marketable securities with suspicion and often discounts
their value.
If the fear of misusing retained earnings is particularly strong, it is
possible that the market will value the firm at less than the value of itsCHAPTER 7 Stocks: Sources and Measures of Market Value 99
(^6) Whether debt is a valuable tax shield depends on whether interest rates are bid up enough to off-
set that shield. See Merton H. Miller, “Debt and Taxes,” Papers and Proceedings of the Thirty-Fifth
Annual Meeting of the American Finance Association, Atlantic City, N.J., September 16–18, 1977,
Journal of Finance, vol. 32, no. 2 (May 1977), pp. 261–275.
(^7) Meeting interest payments may also be a good discipline for management and reduce the ten-
dency to waste excess profits. See Michael Jensen, “The Takeover Controversy: Analysis and Evi-
dence,” in John Coffee, Louis Lowenstein, and Susan Rose-Ackerman, eds., Takeovers and Contests for
Corporate Control, New York: Oxford University Press, 1987.