Case Scenario:
Microsoft has undoubtedly the most successful software firm ever. Between 1994 and 2000, the firms 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 ration of 25.
Microsoft 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 options 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 cost and the associated liabilities and to deal with other imperfections in the statement of shareholder’s equity. Microsoft’s income statement for the first nine months of its June 30, 2000 follows along with its statement of shareholder’s equity at the end of the nine months and the shareholders equity footnote. At the time, Microsoft shares were trading at 90$ each reformulate the equity statement and then answer the questions that follow
Microsoft Corporation
Income statement
(in millions except earnings per share )
(unaudited)
Nine Months ended
March 31, 2000
Revenue 17,152
Operating expenses
Cost of revenue 2,220
Research and development 2,735
Sales and marketing 2,972
General and administrative 825
Other expenses (income) (13)
Total operating expenses 8,739
Operating income 8,413
Investment income 2,055
Gains on sales 156
Nine months ended March 31, 2000
Income before income taxes 10,624
Provision for Income taxes 3,612
Net income $7,012
Earning per share:
Basic $1.35
Diluted $1.27
Stockholder's equity statement (in millions) (unaudited)
_____________________________________________
Common stock and paid-in capital
Balance, beginning of period 13,844
Common stock issued 2,843
Common stock repurchased (186)
Proceeds from sale of put warrants 472
Stock options income tax benefits 4,002
Balance, end of period 20,975
Net income 7,012
Net unrealized investments gains 2,724
Translation adjustments and other 166
Comprehensive income 9,902
Preferred stock dividends (13)
Common stock repurchases (4,686)
Balance, end of period 18,817
Total stockholder's equity $39,792
Extract from the footnotes to the financial statements:
Stockholders’ equity:
During the first three quarters of fiscal 2000, the company repurchases 54.7 million shares of Microsoft common stock in the open market. In January 2000, the company announced the termination of its stock buyback program.
To enhance its stock repurchased program, Microsoft sold put warrants to independent third parties. These put warrants entitle the holders to sell shares of Microsoft common stock to the company on certain dates at specific prices. On March 31, 2000 163 million warrants were outstanding with strikes prices ranging from 69$ 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 share of 2.75$ convertible exchangeable principal-protected preferred stock. Net proceeds of $980 million were used to repurchase common shares. The company’s convertible preferred stock matured on December 15, 1999. Each preferred share was converted in to 1.1273 common shares.
Q1. What was the net cash paid out to the shareholders during nine months?
Q2. What was Microsoft comprehensive income for the nine months?
Q3. Discuss your treatment of the 472$ 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?