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COMM 371 - Project - Optimal Capital Structure.doc

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COMM 371
Paul Hewitt

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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