By 2005, Microsoft Corporation, the premier software firm of the computer age, had matured into an established firm. Maturity, however, often brings slower growth and many observers 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 struggled to make an impact with new products and services. In particular, in Internet-based services that generate subscription, advertising, and transaction revenues, it lagged behind rivals such as Google and Yahoo! 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 acknowledged 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 services. 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 accompanying 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 investors through share repurchases and dividends during the fiscal year. These results provide 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 investment portfolio. The firm's statutory tax rate 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 financial 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?