Microsoft has undoubtedly been the most successful software firm ever. Between 1994 and 2000, the firm's revenues increased from $2.8 billion to $23.0 billion, and its earnings from $ 708 million to $9.4 billion. Over the two year 1998 to 2000, its stock price increased from $36 per share to almost $ 120, giving it a trailing P/E ratio of 66 and a market capitalization at the height of the stock market bubble of over half a trillion dollars. By 2005, Microsoft: was trading at $40 per share (on a pre-split basis) with a market capitalization of $275 billion and a trailing P/E ratio of 25.

Microsoft's success has been due to a strong product, market positioning, and innovative research and marketing. In terms of the buzzwords of the time, Microsoft has significant "knowledge capital" combined with dominant market positioning and network externalities. These intangible assets are not on its balance sheet, and accordingly the price-to-book ratio was over 12 in 2000. Yet, to develop and maintain the knowledge base, Microsoft had to attract leading technical experts with attractive stock option packages, with consequent cost to shareholders. Unfortunately, GAAP accounting did not report this cost of acquiring knowledge, nor did it report significant off-balance-sheet liabilities to pay for the knowledge. Knowledge liabilities, as well as knowledge assets, were missing from the balance sheet. This case asks you to uncover the knowledge costs and the associated liabilities and to deal with other imperfections in the statement of shareholders' equity.

Microsoft's income statement for the first nine months of its June 30, 2000, fiscal year follows, along with its statement of shareholders' equity at the end of the nine months and the shareholders' equity footnote. At the time, Microsoft's shares were trading at $90 each. Reformulate the equity statement and then answer the questions that follow.

Stockholders' Equity

During the first three quarters of fiscal 2000, the Company repurchased 54.7 million shares of Microsoft common stock in the open market. In January 2000, the Company announced the termination of its stock buyback program.

To enhance its stock repurchase program, Microsoft sold put warrants to independent third parties. These put warrants entitle the holders to sell shares of Microsoft common stock to the Company on certain date sat specified prices. On March 31, 2000, 163 million warrants were outstanding with strike prices ranging from $69 to $78 per share. The put warrants expire between June 2000 and December 2002.The outstanding put warrants permit a net-share settlement at the Company's option and do not result in a put warrant liability on the balance sheet.

During 1996, Microsoft issued 12.5 million shares of 2.75% convertible exchangeable principal-protected preferred stock. Net proceeds of $980 million were used to repurchase common shares. The Company's convertible preferred stock matured on December 15, 1999. Each preferred share was converted into 1.1273 common shares.

A. What was the net cash paid out to shareholders during the nine months?

B. What was Microsoft's comprehensive income for the nine months?

C. Discuss your treatment of the $472 million from "proceeds from sale of put warrants." Why would Microsoft sell put warrants? How does GAAP account for put warrants, put options, and future share purchase agreements?

D. If the put warrants are exercised rather than allowed to lapse, how would GAAP accounting report the transactions? How would you report the effect on shareholder value?

E. The equity statement shows that Microsoft repurchased $4.872 billion in common shares during the nine months. The firm had a policy of repurchasing the amount of shares that were issued in exercise of employee stock options, to "reverse the dilution," as it said. Microsoft discontinued the policy in 2000, as indicated in the shareholders' equity footnote. Does a repurchase reverse the dilution of shareholders' equity? Are repurchases at the share prices that prevailed in 2000 advisable from a shareholder's point of view?

F. Calculate the loss to shareholders from employees exercising stock options during the nine months. Microsoft's combined federal and state statutory tax rate is 37.5 percent.

G. The following is the financing section of Microsoft's cash flow statement for the nine months (in millions):

.:.

H. The income statement reports income taxes of $3,612 million on $10,624 million of income. Yet press reports claimed that Microsoft paid no taxes at the time. Can you see why? What does the act of paying no taxes on a large income tell you about the quality of Microsoft's reported income?

I. Review the shareholders' equity footnote. What issues arise in the footnote that should be considered in valuing Microsoft's shares?

Microsoft's annual report for the year ending May 31, 2000, reported the following in the stock option footnote:

Stock Option Plans

For various price ranges, weighted-average characteristics of outstanding stock options at June 30, 2000, were as follows:

The weighted average Black-Scholes value of options granted under the stock option plans during 1998, 1999, and 2000 was $11.81, $20.90, and $36.67, respectively. Value was estimated using a weighted-average expected life of 5.3 years in 1998, 5.0 years in 1999, and 6.2 years in 2000, no dividends, volatility of 0.32 in 1998 and 1999 and 0.33 in 2000, and risk free interest rates of 5.7%, 4.9%, and 6.2% in 1998, 1999, and 2000, respectively.

What information does this footnote give you about the off-balance-sheet knowledge liability for the option overhang? Can you estimate the amount of the liability?