44  Fundamental Principles of Value Creation In most countries, however, borrowing money does change cash flows because interest payments are tax deductible. The total taxes paid by the company are lower, thereby increasing the cash flow available to pay both shareholders and creditors. In addition, having debt may induce managers to be more diligent (because they must have cash available to repay the debt on time) and, therefore, increase the company’s cash flow. On the downside, hav- ing debt could make it more difficult for managers to raise capital for attrac- tive investment opportunities, thereby reducing cash flow. The point is that what matters isn’t the substitution of debt for equity in and of itself; it matters only if the substitution changes the company’s cash flows through tax reduc- tions or if associated changes in management decisions change cash flows. In a similar vein, finance academics in the 1960s developed the idea of efficient markets. While the meaning and validity of efficient markets are sub- jects of continuing debate, especially after the bursting of the dot-com and real estate bubbles, one implication of efficient-market theory remains: the stock market isn’t easily fooled when companies undertake actions to increase reported accounting profit without increasing cash flows. One example is the market’s reaction to changes in accounting for employee stock options, as described in the previous section of this chapter. And when the FASB elimi- nated goodwill amortization effective in 2002 and the International Account- ing Standards Board (IASB) did the same in 2005, many companies reported increased profits, but their underlying values and stock prices didn’t change, because the accounting change didn’t affect cash flows. The evidence is over- whelming that the market isn’t fooled by actions that don’t affect cash flow, as we will show in Chapter 7. A Tool for Managers The conservation of value principle is so useful because it tells us what to look for when analyzing whether some action will create value: the cash flow im- pact and nothing else. This principle applies across a wide range of important business decisions, such as accounting policy, acquisitions (Chapter 31), cor- porate portfolio decisions (Chapter 28), dividend payout policy (Chapter 33), and capital structure (also Chapter 33). This section provides three examples where applying the conservation of value principle can be useful: share repurchases, acquisitions, and financial engineering. Share Repurchases  Share repurchases have become a popular way for com- panies to return cash to investors (see Chapter 33 for more detail). Until the early 1980s, more than 90 percent of the total distributions by large U.S. com- panies to shareholders were dividends, and less than 10 percent were share Conservation of Value  45 repurchases. But since 1998, about 50 percent of total distributions have been share repurchases.15 While buying back shares is often a good thing for management to do, a common fallacy is that share repurchases create value simply because they increase earnings per share (EPS).16 For example, assume that a company with $700 of earnings and 1,000 shares outstanding borrows $1,000 to repurchase 10 percent of its shares. For every $1,000 of shares repurchased, the company will pay, say, 5 percent interest on its new debt. After tax savings of 25 percent, its total earnings would decline by $37.50, or 5.4%. However, the number of shares has declined by 10 percent, so earnings per share (EPS) would increase by about 5 percent. A 5 percent increase in EPS without working very hard sounds like a great deal. Assuming the company’s P/E ratio doesn’t change, its market value per share also will increase by 5 percent. In other words, you can get something for nothing: higher EPS with a constant P/E. Unfortunately, this doesn’t square with the conservation of value, because the total cash flow of the business has not increased. While EPS has increased by 5 percent, the company’s debt has increased as well. With higher leverage, the company’s equity cash flows will be more volatile, and investors will de- mand a higher return. This will bring down the company’s P/E, offsetting the increase in EPS. Moreover, you must consider where the company could have invested the cash rather than returning it to shareholders. If the return on capital from the investment exceeded the company’s cost of capital, it’s likely that the longer-term EPS would be higher from the investment than from the share repurchases. Share repurchases increase EPS immediately, but possibly at the expense of lower long-term earnings.17 However, even if cash flow isn’t increased by a buyback, some have rightly argued that repurchasing shares can reduce the likelihood that management will invest the cash at low returns. If this is true and it is likely that manage- ment would otherwise have invested the money unwisely, then you have a legitimate source of value creation, because the operating cash flows of the company would increase. Said another way, when the likelihood of investing cash at low returns is high, share repurchases make sense as a tactic for avoid- ing value destruction. But they don’t in themselves create value. Some argue that management should repurchase shares when the compa- ny’s shares are undervalued. Suppose management believes that the current 16 O. Ezekoye, T. Koller, and A. Mittal, “How Share Repurchases Boost Earnings without Improving Returns,” McKinsey on Finance, no. 58 (April 2016), www.mckinsey.com. 17 Ibid. 15 T. Koller, “Are Share Buybacks Jeopardizing Future Growth?,” McKinsey on Finance, no. 56 (October 2015), www.mckinsey.com.