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The best use of corporate cash is a subject being pondered by shareholders of Cisco Systems, Inc. (NASDAQ:CSCO) and Microsoft Corporation (NASDAQ:MSFT). Earlier this week, John Chambers, CEO of Cisco, announced his intention to initiate a dividend with a yield of 1% or 2% during the company's current fiscal year. Bloomberg reported that Microsoft was planning a debt offering to fund additional dividends and stock buybacks. The question facing shareholders is whether such moves are in their best interests.

A cash dividend returns earnings to shareholders in a monetary form. Many shareholders like dividends because they provide a stream of portfolio income. Dividend payments should also cause corporate executives to make better fiscal decisions since ceasing the payment of dividends implies that the company is struggling financially. Detractors point out that dividends are subject to double taxation, since both corporate earnings and dividends received in a taxable account are taxed. The payment of dividends also conveys an aura of slower growth.

A stock buyback returns earnings to shareholders in a non-monetary form. As shares are repurchased and retired, each shareholder's proportionate ownership increases. This is because there are fewer shares outstanding to lay claim to a company's earnings stream and its assets. Stock buybacks give executives more flexibility since there is no negative connotation associated with repurchasing fewer shares than allowed by the announced size of the program. Detractors point out that buybacks artificially increase earnings per share, since net income does not change. (In other words, though each slice of the earnings pie is bigger, the size of the earnings pie does not change.) Repurchase programs also do not place the same level of fiscal responsibility on executives that dividend payments do.

Neither dividends nor share buybacks enhance the business prospects of the company. Rather, both programs result in a net outflow of cash--cash that could have otherwise been used for potentially profitable ventures. Every dollar of cash that is returned to shareholders is a dollar that cannot be spent on product development, plant expansion or acquisitions.

This is not to say that dividends or buybacks are bad things. In fact, they are preferable to ill-fated acquisitions, bad business decisions and lackluster product lines. For example, Microsoft's Zune music player has been a dud and the company has struggled with marketshare in both the smartphone market and the finally emerging tablet computer market. Plus, it is not an either/or scenario: A well-managed company should be able to pay a dividend, repurchase stock and fund new business ventures. (Cisco has made several successful acquisitions and has repurchased its stock.)

Finally, there will be scenarios where the best choice is to not return cash to shareholders. This is the case when opportunities for growth provide the most economic value or during periods when business is weak enough to favor the conservation of cash.

Keep in mind that there are external factors to consider, such as the cost of accessing capital. Bloomberg reported that Microsoft had $22 billion in free cash flow last year, with about half of that balance overseas. Because of U.S. tax laws, it would be costly for the company to repatriate the money. Thus, though Microsoft holds a large cash balance, returning it directly to shareholders may not make financial sense. (It is likely cheaper to raise debt in the U.S. and distribute the proceeds of the bond offering to shareholders than to tap the current overseas reserves.)

The key for investors is to determine whether or not the company is making the best decisions as to how to spend its cash balance. This is not always an easy question to answer, but paying attention to the success of previous new products, ventures and acquisitions as well as the company's ability to continuously generate positive cash flow can provide insight.

THE WEEK AHEAD

The initial reporting period for third-quarter earnings continues next week. Among the 15 S&P 500 members scheduled to announce results are Discover Financial Services (NYSE:DFS) on Monday, Adobe Systems (NASDAQ:ADBE) on Tuesday, General Mills (NYSE:GIS) on Wednesday and Nike (NYSE:NKE) on Thursday.

The Fed will hold a one-day meeting on Tuesday. Given the ongoing debate within the Federal Open Market Committee about whether additional monetary stimulus is needed, there may not be any signficant change in the Fed's ongoing debt purchase programs.

The September National Association of Home Builders (NAHB) housing index will be published on Monday. August housing starts and building permits data will be released on Tuesday. Thursday's economic reports include August existing home sales and The Conference Board's August leading indicator index. August durable goods orders and new home sales numbers will be published on Friday.

Chicago Federal Reserve Bank President Charles Evans will make a public appearance on Thursday. Richmond Federal Reserve Bank President Jeffrey Lacker and Philadelphia Federal Reserve Bank President Charles Plosser will speak on Friday.

Source: AAII Investor Update: Dividends and Buybacks- A Good Use of Corporate Cash?