By 2005, Microsoft Corporation, the premier software firm of the computer age, had ma- tared into an established firm. Maturity, however, often brings slower growth and many ob- servers claimed that Microsoft was beginning to show such symptoms. Outside its core business centered around the Windows operating systems and related applications such as Microsoft Office, the firm had straggled to make an impact with new products and services. In particular, in Internet-based services that generate sobscription, advertising, and transac tion revenues, it lagged behind rivals such as Google and Ykhool. Apple's recent launch of its iTunes music service and its success with iPod left Microsoft looking somewhat dated. At its annual meeting with analysts on July 28, 2005, Chairman Bill Gates acknowl- edged that Microsoft was "playing catch-up on search" but added that, within three years, it would make significant advances over the current state of the technology. CEO Steve Ballmer announced a new focus on growth through an expansion into Internet services. The software industry, he insisted, was moving from "delivering bits to delivering bits and ser- vices. The Internet's transformative impact on the software business has just begun." The shift from software to services was hailed as a new business model for generating growth. New areas would involve communications, Web-based storage, and tools to permit workers to collaborate better, Analysts advised caution. Few details of the new plan were offered at the meeting, and Microsoft had previously emphasized Web-services initiatives with less than stellar results. Despite the skepticism about Microsoft's ability to deliver growth, the press release ac- companying fiscal 2005 results indicated otherwise. "We closed out a record fiscal year with strong revenue growth in the fourth quarter driven by healthy, broad-based demand across all customer segments and channels," said Chris Liddell, chief financial officer at Microsoft. "While continuing to invest in the business, we also returned $44 billion to in- vestors through share repurchases and dividends during the fiscal year. These results pro- vide solid momentum heading into fiscal 2006, which is shaping up to be a strong year for growth and investment. We expect double digit revenue growth next year, kicking off the strongest multiyear product pipeline in the company's history" ! Microsoft's income statements for 2002-2005 and balance sheets for 2001-2005 are summarized in Exhibit 12.3. The income statements are supplemented with details of other comprehensive income reported in the equity statement. Reformulate these statements, being sure to distinguish operating activities from financing activities and, within operating activities, income from Microsoft's core software business from income from its invest- ment portfolio. The firm's statutory tax cate is 37 percent. Discuss the following. Use a required return of 9 percent if needed for calculations. A. With valuation in mind, what measures would you focus on to evaluate Microsoft's growth from 2002 to 2005? Focus on the core business rather than investment income. Would you say that Microsoft has been a growth company? Is there any indication that growth is slowing? B. Explain the change in return on common equity (ROCE) for 2005 over that for 2004. C. Microsoft paid out $44 billion to shareholders during fiscal year 2005, including a large special dividend of $33.5 billion. Explain how such a big payout affects return on common equity (ROCE). What would Microsoft's ROCE for 2004 have been if its fi- nancial leverage had been the same as that at the end of 2005? It has been said that firms can increase ROCE simply by selling off their holdings of Treasury bills. Is this true? D. Microsoft has considerable unearned revenues. Analysts have been concerned that Microsoft might use these deferred revenues to create earnings growth. How could this happen? E. Examine Microsoft's investment income. Is there any suggestion of cherry picking? Real World Connection Microsoft Exercises are E1.6, E4.16, E10.10, and E17.10. Minicase M8.2 also covers .

Yearly Income Statements (in billions of dollars) 2005 2004 2003 2002 Revenue 39.79 36.83 32.19 28.35 Operating expenses Cost of revenue 6.20 6.72 6.06 5.30 Research and development 6.18 7.78 6.60 6.30 Sales and marketing 8.68 8.30 7.55 6.25 General and administrative 4.17 5.00 243 184 25.23 27.80 22.64 20.09 Operating income 14.56 9.03 9.58 8.27 Investment income 2.07 3.17 1.50 (0.40) Income before taxes 16.63 12,2 11.05 787 Income taxes 4.38 4.03 3.52 2.51 Net income 12.25 817 7.53 5.35 Investment income is comprised of the following: Interest income 1.27 1.67 1.70 1.76 Dividends 0.19 0.20 0.18 0.27 Realized gains (losses) on investments 0.61 1.30 10.38) (243) 2.07 3.17 1.50 (0.40) Other comprehensive income (from equity statementy Gairs osse) an derivatives 10:06 010 (0.10) (0.09) Unrealized investment gains (loss) 037 (0.87) 1.24 0.01 Translation adjustments 0.0 0.05 0.12 0.08 0.31 10.72) 1.26 0.00 Yearly Balance Sheets En billions of dollars 2005 2004 2003 2002 2001 Cash and cash equivalents 4.85 15.98 6.44 3.02 3.92 Short-term Investments 32.9 44.61 42.61 35.64 27.68 Accounts receivable 7.18 5.89 5.20 5.13 3,67 inventories 0.49 0.42 0.64 0.67 0.08 Deferred tanes 1.70 2.10 2.51 2.11 1.52 Other 1.62 1.57 157 201 2.34 Total current assets 48.74 70.57 58.97 48.58 39.21 Property and equipment 2.35 2.33 2.22 2.27 2.31 Equity investments 10.10 10,73 11.83 12.19 12.70 Debt investments 0.90 1.48 1.85 2.00 1.66 Goodwill 331 3.12 3.13 1.43 1.51 Intangible assets 0.50 0.57 0.38 0.24 0.40 Deferred taxes 3.62 1.83 2.16 Other long-term assets 1.30 1.76 1.18 0.94 1.04 Total assets 70.82 92.39 81.73 67.55 58.83 Accounts payable 2.09 1.72 1.57 1.21 1,19 Accrued compensation 1.66 1.34 1.42 1.15 0.74 Income taxes payable 2.02 3.48 2,04 2.02 1.47 Short-term unearned revenue 7.50 6.51 7.23 5.92 4.40 Other abilities 3.61 1.92 1.71 2.45 1.45 Total current liabilities 16.88 14.97 13.97 12.75 9.25 Long-term unnamed revenue 1.67 1.66 1.79 1.82 1.22 Other long-term liabilities 4.15 0.93 106 090 1.07 22.70 17.56 16.82 15.47 11.54 Shareholders' equity 48.12 74.83 64.91 52.18 47.29 70.82 92.39 81.73 67.65 58.83 -