Payouts to Shareholders  657 taxes (NOPAT) of $100, which translates to an enterprise value of $1,500 (at an enterprise-value-to-NOPAT multiple of 15 times). The company has an excess- cash position of $100, no debt, and 100 shares outstanding. It can decide to hold on to the cash or use it to repurchase shares, pay dividends, or invest in operations. Shareholder value increases for the investment alternative because the return on capital exceeds the cost of capital. But it remains unchanged for the other three alternatives, even though the associated changes in EPS or P/E appear to indicate otherwise. The exhibit compares all four alternative cash deployments in detail: 1. Hold cash. In this case, the company keeps the excess cash, and net in- come for the upcoming year is $102 (assuming the after-tax interest rate on the $100 cash is 2 percent). The company’s value per share is $16, EPS is $1.02, and the P/E is 15.7. 2. Repurchase shares. The company uses its $100 in cash to buy back 6.25 units of its own shares (equal to $100 divided by a share price of $16). The value per share is unchanged at $16 (the remaining equity value of $1,500 divided by 93.75 remaining shares). But the EPS increases to $1.07, even though no value is created. This is simply due to the fact that the P/E for cash is higher than for shares.43 After the share buyback, the company’s equity has a lower P/E because leverage is now higher. The decline in P/E cancels out the increase in EPS, keeping shareholder value unchanged. 3. Pay dividends. The company pays a $1 dividend on each of its 100 shares outstanding. Although the value per share declines from $16 to $15, each shareholder still ends up with a total value including dividends of $16 per share. Again, there is no value creation, but now the EPS declines to $1.00 because the interest-generating cash has been paid out to the shareholders. The P/E for the company’s equity also declines, because leverage increases due to the cash payout. The lower EPS and P/E tie with the decline in value per share of $1, which is exactly equal to the dividend paid per share. 4. Invest. The value for shareholders does change when the company can invest the $100 in the business at an after-tax return (ROIC) of 15 per- cent. At a constant enterprise-value multiple of 15 times, the enterprise and equity value will increase to $1.725 (as NOPAT increases to $115 from $100). Because of the high return on investment, the EPS increases to $1.15, clearly above any other scenario. The value per share is now $17.25, higher than in all other scenarios, because the business invest- ment creates $125 additional value for shareholders ($1.25 per share). 43 The P/E for cash in this example is 50 times (equal to the inverse of the after-tax interest rate of 2 percent). 658  Capital Structure, Dividends, and Share Repurchases The erratic pattern of EPS changes across the alternative allocations dem- onstrates that it does not move in line with value creation. Even though it is highest for the alternative with the highest value creation, this does not mean EPS is a reliable indicator of value creation. For example, assume that the investment would not produce operating earnings in the upcoming year, but only after several years. Of course, the investment would still create value.44 But now the EPS would not increase to $1.15; it would instead decline to $1.00. Also, changes in the P/E would send the wrong signal. Delayed earn- ings would further increase the P/E for the investment alternative, not be- cause value creation is higher, but simply because the company’s earnings for the upcoming year would be lower. Exhibit 33.14 also shows that share repurchases can destroy value if they prevent the company from pursuing attractive investment opportunities. This underlines that payout decisions, whether repurchases or dividends, always need to be considered as part of a company’s overall cash deployment. EXHIBIT 33.14  Value Creation from Share Repurchases vs. Alternatives for Cash Deployment $ Hold cash Repurchase shares Pay dividends Invest Earnings per share NOPAT1 100.0 100.0 100.0 115.0 After-tax interest income (expense)2 2.0 – – – Net income 102.0 100.0 100.0 115.0 Number of shares 100.00 93.75 100.00 100.00 Earnings per share 1.02 1.07 1.00 1.15 Enterprise and equity value Enterprise value/NOPAT 15 15 15 15 Enterprise value 1,500.0 1,500.0 1,500.0 1,725.0 Cash 100.0 – – – Equity value 1,600.0 1,500.0 1,500.0 1,725.0 Pay out: Dividends 100.0 Pay out: Share repurchases 100.0 Equity value including payouts 1,600.0 1,600.0 1,600.0 1,725.0 Value per share Value per share 16.00 16.00 15.00 17.25 Dividend per share – – 1.00 – Value per share including dividends 16.00 16.00 16.00 17.25 Price/earnings 15.7 15.0 15.0 15.0 1 Net operating profit after taxes. 2 After-tax interest rate on cash is assumed to be 2% per year. 44 Assuming the same 15 percent ROIC and 15 times enterprise value multiple.