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Analyzing Microsoft's Cash Position Alpa Dhanani anaging cash is an integral part of running any business. Companies require cash for investments into new profitable projects, to pay for day-to-day running costs, and often to distribute to investors as a means of rewarding them for their investments and encouraging further investments. While accounting systems in the US and round the world generally rely on profits as a measure of success 1, the cash flow position of firms has also more recently been recognized as a critical indicator of business success.2 Indeed, the primary concept upon which the theories of finance are based is to maximize the present value of future cash flows of a company in an attempt to maximize shareholder wealth. While cash is critical for business success and is also one measure of this success, holding too much cash within a corporation may lead to an inefficient use of the resource. Thus, an optimal cash balance is required to maximize value for shareholders.
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Cash management from the finance perspective can be categorized into two strands. The first deals with generating optimal cash levels for the day-to-day running of the business (models here include the Baumol and the Miller-Orr cash management models). The second strand is concerned with cash issues at a higher level, where investment, financing and dividend policy decisions for the long-term are taken as a part of the company's overall strategy. Both are important management aspects in their own right; the analysis here is concerned with the latter. The remainder of this discussion analyzes the cash situation at Microsoft. In particular, it introduces this situation and then looks into the company's strategic position, financing strategy, strategic investments, financial investments, dividend policy, and agency theory. Microsoft, as stated in the case, reported an astounding cash level of $62.7 bn, which is larger than that ever recorded before for a non-financial company. The primary reason cited for this was that it gave the company, which operates in a high risk industry, a level of financial stability and flexibility that enabled it to manage competition, legal battles and pursue its strategic investments and acquisitions. Microsoft is a company that has relied on an intra-industry expansion strategy to provide value to its shareholders. The company has witnessed enormous growth since its incorporation in 1981 (see annual reports) and has exhibited varied developments in the software industry. Microsoft's strategy is similar to several of the `dot-com' companies of the 1990s (though several of these companies subsequently failed). This intra-industry expansion strategy makes for a very contrasting comparison with other large, successful, global conglomerates, which have invested in a variety of different businesses. 3 This strategy has important capital investment implications for the company. Microsoft relies primarily on internally generated funds for its investments. The company shows a very low gearing level and has also recently exercised share repurchases as a way to reduce its external equity funding. 4 There are two key, though interrelated benefits of using internally generated funds: it is a less expensive way to raise finance for capital investments and other high

outlay requirements; it is an easily accessible form of finance. Internally generated funds are a common source of funding for companies operating in industries with extensive research and development (R&D) expenditure. This is because the uncertainty associated with research and research outcomes, may require high injections of cash. will result in high risk for investors if external sources are used, who will in turn demand high returns to compensate them for the risk. 5 Further, where costs such as the possible legal charges faced by Microsoft are concerned, internally generated funds are really the only way of funding, as markets will be unwilling to provide funds for such causes. The company's investment strategies can be categorized as strategic and financial. The former refers to capital investments undertaken to further the core aspect of the business: Computer software. The financial investments at Microsoft refer to investments in the equity and bond markets, both locally and internationally, as a way with which to manage the company's cash resources. From the viewpoint of strategic investment, an analysis of the cash flow statement indicates that the company has invested a very small amount into physical resources and corporate acquisitions in the last few years. R&D expenditure, though, is high and represents approximately 30% of total operating expenses year on year. The former situation is, perhaps in part, explained by the fact that Microsoft does not operate in a resource intensive industry, and much of the strategic progression is through R&D. Acquisitions, nonetheless, remain low. Given that the company has chosen to rely on intra-industry expansion, opportunities for growth through acquisitions are few and far between. An overall analysis of the financial statements indicates that Microsoft invests on average 10% of its current cash resources into R&D on an annual basis. This suggests that it is holding far more cash than that required for its R&D program, even after taking into consideration that this is a critical aspect of the company's business. To continue to remain within the remit of the software industry, Microsoft has refrained from investing directly6 in other industries; yet it has large cash levels. The company has chosen to invest this surplus cash from current projects into actively managed security investments (see the cash flow statements for an indication of the level of investments). In essence, the company appears to have engaged in a new business venture, that of managing cash resources on part of investors using its internally developed computer model. 7 One issue that arises from the high cash levels at the company is whether it should return this surplus cash to its shareholders. The company has, for the first time in 2003, paid a cash dividend to its shareholders. It would appear that Microsoft's shareholders are seeking returns through growth (capital gains) rather than cash dividends. When investing in a company with exponential growth potential, shareholders are aware that it will reuse the cash generated as part of its expansion strategy and that a dividend payment is unlikely; they have chosen such an investment. Shareholders may prefer such a growth strategy for various reasons8. One of the difficulties that Microsoft now faces if it makes dividend payments from excess cash levels is that it may fail to meet shareholder expectations of `capital gains' based shares vs. cash dividend shares. Further, such a dividend policy may send a negative signal to shareholders that the company is no longer able to develop profitable new projects to invest in. This perhaps explains why the company has been reluctant in making a dividend payment until now. A second, but interrelated issue that the company may need to consider is once it decides to make regular dividend payments, it would need to determine the level of this payment, so that it can be sustained in the foreseeable future. Failure to make regular and stepwise increasing payments also often sends negative signals to the

investor community, in which the performance of the company is questionable because it is unable to keep up with commitments of prior years. A special dividend, which is treated as a one-off dividend payment might be a more appropriate strategy for the company. The final consideration is agency problems. When companies such as Microsoft generate such large cash resources, a key concern for shareholders is that internal managers may use the cash unwisely for their own benefits and at the detriment of the shareholders. Dividends are usually seen to curb such action, as any excess cash is returned to the shareholders. At Microsoft, agency problems between shareholders and managers are unlikely to feature. This is because the executive officer and directors of the company hold a significant proportion of the shares (17.3%) and consequently are unlikely to operate in the disinterest of the shareholder community as their shares too will suffer from such action. In conclusion, the cash resources are a product of the success of Microsoft's core business and its creation of a portfolio investment into stocks and securities. While the company requires high cash levels for its R&D program (plus expenses for legal charges) and internally generated funds may be ideally suited to this cause, the cash held is still significantly higher. It appears that the company has engaged into a business venture to actively manage a portfolio of investments, and is using this as a way to retain shareholder funds without diversifying into other businesses in an attempt to expand. Shareholders have little concern over agency problems, and the company also appears to be careful with its dividend policy to ensure that it is operating in the best interests of its shareholders. The author is lecturer in Accounting, Cardiff Business School, UK. Not Much to Worry About Alison Rampersad Microsoft's Money The software giant Microsoft has generated billions of dollars for itself, its leaders, its employees, and its competitors during the past 20 years. Due to the company's monetary success and market share, the corporation's founder and Chief Software Architect, Bill Gates, is often viewed as `greedy.' Also, the corporation's image has become tarnished by anti-trust suits, corporate scandals, and myths of huge sums of money being diverted to its corporate leaders. For those who wonder where the money goes, there is the stark realization that a huge corporation like Microsoft experiences large deficits that eat away at its revenues. Often ignored, too, are the many venues for philanthropy that sanction the corporate responsibility of an institution. There are those who argue that as Microsoft's bottom line continues to increase, wealth distribution to its shareholders should also increase proportionately. But current stock market woes have adversely affected the value of the company's stock, along with that of many other major corporations. That, however, has not kept Microsoft from adhering to its global community commitment and establishing its place as a long-term contributor. Corporate Responsibility In an ABC television interview with Good Morning America's Charlie Gibson on January 15, 2004, Melinda Gates, wife of Bill Gates, discussed the latest round of dollars given by Microsoft to charity, $6 bn. Since its inception in 1999, the Bill and Melinda Gates Foundation has allocated $26 bn to various organizations including the Salvation Army, the California Early College Academy at the University of California (Berkeley), numerous public libraries throughout the US for computer labs and computer training, AIDS prevention programs (both inside and outside the US), as well as grants for promoting learning and global health.

Bill Gates continues to reshape Microsoft's commitment to supporting and enhancing the Internet, to making Internet access and programs available to young people who otherwise would not be able to realize their potential, and to providing tools and resources to both teachers and students. Over the years, Microsoft has been a major sponsor of events like the 2002 Winter Olympic Games in Utah. Corporate support of this magnitude requires a large, unwavering financial commitment and the willingness to go the distance even in the face of opposition. Entrepreneurial Spirit Microsoft's leadership has a history of being in the right place at the right time, and an aggressive policy of pursuing new product development, capitalizing on existing technology, acquiring in-process technology, and even purchasing competing companies. And that requires money. Bill Gates and Steve Ballmer were there when IBM, the then personal computer industry leader, had a computer without an operating system and did not have the technology to create one. Gates had a vision and Ballmer had a way of putting it into words; DOS was born, marking the beginning of an empire. After that, it was just one skillful move after another. Gates made a deal to `license' DOS rather than sell it to IBM, knowing what a money-maker it would be and `seeing' where the technology would lead. Both Ballmer and Gates have stated that they expect to be in the business for a long time. With that thought in mind, Microsoft's leadership has had to plot a strategy to stay the course, one that will take them through both profitable and turbulent times: roller coaster stock performance, high employee turnover rates, technological innovations and flops, and other day-to-day, behind-the-scene problems. Recent Industry Evils A 1998 study done by McKinsey & Co. (a consulting company), shows that Microsoft only got 4% of the revenue in the markets it dominated (e.g., operating system and office suite). Thus, 1998's $383 bn put $15.3 bn in Microsoft's pockets and $367.7 bn in its partners' pockets. If that 4% holds steady, Microsoft got $22.9 bn last year, while its partners got $550.1 bn! This means that `Microsoft has created considerable wealth for many other companies.' 1 In the past, Microsoft has played `big brother' to smaller enterprises by providing them funding, accounting services, leadership, and office facilities. This has taken its financial toll. On the flipside, however, it has failed to get the support of major partners in its effort to make the .NET Project an industry standard for XML Web services. There have also been heavy accounting costs due to upgrades and reactivations. The company's envied success and seemingly unchecked resources often make it a target for expensive legal battles, creating a major financial drain. Constantly having to update obsolete Windows code to keep abreast of competitor's attempts to grab market share and to keep Microsoft on top also has it financial obligations. Software piracy continues to be an ongoing dilemma which detracts from shareholders' returns. As if these were not enough, on the back of the recent demise of dot-coms, IBM endorsed Novell, the first, and a leading competitor of network operating systems in the industry, putting an end to its long time promotion of Microsoft's Windows NT and Windows Server network operating system products. During the past five years, scores of software viruses and worms have targeted security breaches in its Outlook product, and Microsoft has taken a major financial hit in reparations to ravaged clients and in rewards to those providing information to apprehend and punish those responsible for the destruction. Hotmail is no longer safethere are Internet instructions guiding one to easy entry into others' mailboxes. And Microsoft has suffered a rash of other major security issues in the past three years. Hackers have sent massive amounts of junk data to Microsoft's computers, overwhelming them. "Internet users had trouble viewing the MSN portal, Microsoft's corporate site, the 89 million-strong Hotmail e-mail site, the

MSNBC.com news site, and the Expedia.com travel site." 2 Microsoft has suffered a drop in unearned revenue as a result of an increase in the cancellation of multi-year contracts it held. In addition, the corporate giant has undertaken a buyback of mostly worthless stock options from its employees. "Overall, Microsoft made a $1.55 bn profit, or 14 cents a share, for the quarter ended December 31, 2003, a 17% drop from a profit of $1.87 bn, or 17 cents a share, a year earlier."3 Microsoft's Real Financial Strength Bill Gates and Steve Ballmer are an unbeatable team with a strong cadre of products. As they lead Microsoft into the new millennium, it will not be without their share of difficulties, financial and otherwise. Despite Microsoft's commitment to building a better world through technology and its applications, and its ability to continue to create financial wealth through strong leadership, there will be constant speculation about the corporation's financial status and distribution of wealth. It will then be up to Microsoft to continually demonstrate to both shareholders and stakeholders, the financial power of its convictions. The author is visiting professor in the college of business and management at Lynn University, Florida, US. References 1. Bill Parish, Taking a Closer Look at Microsoft, April 20, 2003, www.billparish.com. 2. Olympic Gold: Financial Situation of the Salt Lake Organizing Committee, September 2001, CFO, Magazine for Senior Financial Executives. 3. Microsoft's Financial Future, February 23, 2001, www.geek.com. 4. Microsoft Hits Brick Wall, April 11, 2002, www.aaxnet.com. 5. Jeff Adkins, Microsoft's `Tsunami' memo: The Read Text, January 21, 2002, www.lowendmac.com. 6. Gina Shaw, Moving a 2,000 Pound Gorilla, March 13, 2003, www.CRMIQ.com. 7. Adam Lashinsky, Microsoft's Snapshot is a Portrait of Strength , July 27, 2001, Market News, SiliconStreet.com. 8. Microsoft's Sales Sizzle but Profit Slips During Last Three Months of 2003, January 23, 2004, The Seattle Times, at www.kiplinger.com. 9. Will Microsoft Enter the Antivirus Market? January 29, 2004, www.forbes.com. 10. Hacker Attack Blocks Access to Microsoft's Websites, January 26, 2001, www.NewsMax.com 11. John Del Vecchio, Is Microsoft Undervalued? February 22, 2001, www.fool.com. 12. Ina Fried, Microsoft to Award Stock, Nix Options, July 8, 2003,

www.news.com. 13. www.microsoft.com Reference # 14-04-02-