Optimal Capital Structure Plurality in Software Publishing
A Case Analysis: Microsoft & Oracle
James Hillier 84435064
Michael Kowbel 82547043
Parker Wright Microsoft and Oracle are two of the largest software development companies in
the ever-expanding technology sector. Though they share many similarities in industry
and specialization, they have starkly contrasting capital structures and cash policies. In
understanding the capital structure of a corporation, there are four principle theories
which affect the decisions managers make to determine the optimal ratio of debt-to-
equity to maintain for the corporation. These theories are the static trade-off theory, the
market timing theory, the stakeholder theory, and the pecking order theory; all theories
influence a corporation’s cash policy. However, these theories can be contradicting on
certain elements and it is indeterminate if any of these theories could lead to a conclusive
universal policy to determine the optimal capital structure of a corporation.
Our analysis intends on addressing the lack of a universal explanation of the
capital structure and cash policies of industrially similar but financially differing
corporations. By examining the rationale behind the historical cash and capital structure
policies of Microsoft and Oracle, we will test the theories behind capital structure and
examine how it leads to differing cash policies. The conclusion of this analysis is that
there is no universally applicable optimal capital structure, and rather that each of the
theories represent a different optimal methodology and that these theories can
dynamically interact and co-jointly determine the final optimal capital structure and cash
policy of a corporation given its history and expectations.
Microsoft - MSFT
Microsoft underwent a dramatic change in cash policy in July of 2004. It was in
this year that Microsoft recognized itself as a mature cash cow capable of sustaining itself
without hoarding a titanic war-chest of cash to fund acquisitions or to protect its market
position within the volatile technology sector. It was at this juncture in 2004, that the
board of directors announced that it would pay a $3.00 per share special dividend that
would be collectively worth $32 billion. This was concerted with a four-year share
i
repurchase program valued at an additional $30 billion and a $0.08 quarterly dividend.
Clearly, Microsoft had recognized its position in the technology sector and was
restructuring its cash policy accordingly.
What events led to this paradigm shift? There are several explanations.
Microsoft believed the technology sector had rebounded following the 2001 crash and
that it was no longer necessary to maintain a large cash reserve to insulate itself from
systematic shocks to the tech sector and that the cash would be more productive in the
hands on investors. Microsoft’s five year ROE was 16.18%, which is below the 18.27%
that the S&P 500 returned, thus transferring the cash to shareholders is economically
rational and consistent with the agency principle. More importantly, Microsoft
recognized that there were regulatory constraints to its growth imposed by anti-
competition bureaus in both the European Union and the United States. Microsoft was
growth constrained by recently settled and still pending lawsuits with competitors. As
stated in the 2004 form-10k “the operating income decline of $511 million was primarily
caused by the $2.53 billion of charges related to the Sun Microsystems settlement and a
fine imposed by the European Commission.” Additionally, there remained a lawsuit
pending with Time-Warner, there was a recently settled lawsuit with the California public
schools, there was a recently settled anti-competitive lawsuit with Apple and the US
Justice Department, and to this very day Microsoft remains under the threat of a fine of two million euros per day by the EU for not complying with competition regulators.
Contingent liabilities based on Microsoft’s alleged abuses continue to be an important
factor in future considerations to Microsoft’s overall business strategy. The ability for
Microsoft to grow within the software was recognized by management to be impeded by
its already dominant shadow.
While the cash policy was undergoing a significant metamorphosis, the capital
structure was also undergoing significant changes. Perhaps one of the most enigmatic
iii
facts about Microsoft is that it has “no material long-term debt.” The lack of long-term
tax-deductible debt is inconsistent with the static trade-off theory and M&M proposition I
as theoretical expectations would foresee Microsoft leveraging its equity. Microsoft’s
long-term liabilities are generally contingent liabilities from unresolved litigation and
taxation, and are thus not entirely congruent with the orthodox definition of leverage.
However, interest from short-term borrowing is also tax-deductible if the liabilities are
related to operations, as Microsoft’s current liabilities are structured. This leads to the
important insight that Microsoft in fact does lever itself.
Microsoft debt generally comes in the form of short-term liabilities which are
structured mostly through short-term payables. The natural question is what compels
Microsoft to maintain zero long-term debt? Moody’s rates Microsoft’s long-term debt as
AA and the short-term debt rating is P1. This means that in the long-term debt market,
Microsoft will have to pay a higher risk premium, whereas in the short-term market,
Microsoft can obtain the lowest rate available. Long-term debt has a higher duration and
is most sensitive to interest rate risk and will charge a high rate. Thus, Microsoft’s
preference for short term debt can be explained by its ability to borrow at the short-term
prime rate, by liquidity preferences, and by the current inverted interest rate yield curve
with expectations calling for a cut in rates over the medium term. vi
Microsoft’s debt-to-equity ratio (D/E) has spiked upwards since the 2004
financial overhaul, and it currently sits at 0.74, which viinotably lower than that of Oracle
but in line with the average for software publishers. Microsoft’s maintenance of the
industry D/E average is consistent with the static trade-off theory as permanent losses of
value from financial distress can be expected to be systematically consistent, thus
Microsoft is maximizing tax benefits from debt at the margin. We believe that before
2004, Microsoft had a policy of maintaining spare debt capacity as a measure of
economic conservatism and to finance future growth and acquisitions. With the
reorganization of 2004, Microsoft ended its policy of conservatism and realized that
continued acquisitive behaviour would be viewed as predation. Subsequently the spare
debt capacity was exercised to realize the full tax benefits.
We conclude that due to fears of continued anti-competitive allegations,
Microsoft resignedly accepted that its growth opportunities would be limited to below its
internal growth rate and that any future growth opportunities could be entirely funded by
internally generated cash flows as is consistent with the pecking order theory. Microsoft
itself states that “existing cash and short-term investments, together with funds generated
from operations should be sufficienviii meet operating requirements, quarterly dividends
and planned share repurchases.” We believe this is a correct presumption when
consideration is given to the operating cash flows averaging $15.2 billion over the past
five years and to the rampant growth in net income, which has grown 235% over that
same period, despite the substantial legal expenses (see table one). Consistent with the static trade-off theory, Microsoft chose the industry average capital structure to maximize
the value of existing operations through t
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