The failure Microsoft Corp.'s Yahoo acquisition bid has put the Redmond, Wash., company in a familiar predicament: What should it do with all its cash?

A potential answer surfaced last week, with the news that a top Wall Street analyst believes Microsoft will spend as much as $20 billion buying back its own shares in the next three months.

Microsoft didn't comment on the prediction by analyst Heather Bellini of UBS AG, as reported by Bloomberg News.

But the situation provides a glimpse into the mind-set of Microsoft executives, who have suggested that the market is underestimating the company. Companies buy back their own shares when they believe investors undervalue them, making them a good deal.

The situation also shows how investors are feeling. As a group, they've made it clear that they would rather see the company return the cash through a buyback or dividend than spend it on giant acquisitions or internal projects. Microsoft shares rose after the report and finished Friday at $28.13 - an increase of 11 percent on the week.

In contrast, the stock market previously panned Microsoft's plan to spend a big portion of its cash to acquire Yahoo.

The market's response to last week's buyback report seemed to reflect relief that Microsoft was "not going to do something crazy" with the cash, said Tim Allen, analyst and portfolio manager at the Wentworth, Hauser and Violich investment firm in Seattle.

The basic concept behind a buyback is to reduce the number of shares in the market, which boosts the key financial measure of earnings per share. The hope is to increase the share price in the process, but that doesn't always happen.

Speaking to analysts last month, Microsoft Chief Financial Officer Chris Liddell pointed out that the ratio of the company's share price to its earnings was at the lowest point in its history. In other words, Microsoft executives suggest, investors aren't giving the company proper credit for its financial results and potential.

At the meeting, Liddell showed the trend in Microsoft's share price and called it "an incredibly frustrating chart for us internally." Microsoft shares were trading below $26 at the time, down from more than $37 in November. Much of the decline followed Microsoft's Jan. 31 bid to buy Yahoo.

Microsoft had planned to go into debt for the first time to help finance that $44.6 billion acquisition bid. Microsoft also reduced its volume of ongoing stock buybacks to preserve more cash for the deal. But the companies couldn't come to terms, and Microsoft's balance of cash and short-term investments was more than $23.6 billion as of June 30.

Now, the share price presents an opportunity for more buybacks, Microsoft executives say. Without going into specifics, Liddell foreshadowed the buyback plans during the July meeting with analysts. Based on the share price, he said, "the buying opportunity, at least from an internal point of view, makes more sense than it ever has."

Microsoft issues a quarterly dividend of 11 cents per share. But given the choice between buying back shares and significantly boosting the dividend, Liddell said last month that he would choose the buyback, given the company's low share price.

The company's cash balance was more than $60 billion in 2004. The company had been facing the prospect of large legal payouts as a result of numerous antitrust cases. In July 2004, Microsoft announced a one-time special dividend of $3 per share, along with a big increase in share buybacks.

Microsoft spent $19.7 billion and $27.1 billion buying back its own shares in its 2006 and 2007 fiscal years, respectively. The company reduced the buybacks to $12.4 billion in its 2008 fiscal year, which ended June 30, primarily because it was socking away cash to pay for a Yahoo acquisition.