Company Name: Microsoft Corporation (MSFT)
Microsoft is a corporation that was founded in 1975. The company provides businesses and
individuals with the technology they need to maximize their experience. This includes entertainment,
work, and any other aspect of life that can be enhanced by technology. Microsoft offers a vast number of
products ranging from the classic Windows computer software to the Xbox gaming systems.
Stock: The price of Microsoft’s stock in the market on Monday morning was $47.52i. With
8,239,000,000ii shares outstanding the market capitalization Microsoft has is $391,517,280,000.
Geographyii:
Revenues
Employees
United States
$41,344,000,000
58,000
Other Countries
$36,505,000,000
41,000
Cost of Equity = 2.53% + 0.833 (6.02% + 0.6%) = 8.04%
The first element that needs to be identified to calculate cost of equity is the risk-free rate. This
month’s average daily treasury yield curve for a 10-year termed bond was used to get 2.53%iii. Taking an
average of the months eliminates daily fluctuations that may be considered statistical noise and a term of
10-years was chosen to be comparable with international rates (A1). By not attaching a default risk to
this I am assuming that the United States government has no chance of defaulting.
The market risk premium that was chosen to value Microsoft was 6.02% from the chapter 2
readingiv. They arrived at this number by taking stock returns over Treasury bond returns using the
arithmetic average from 1994-2003. This time period was chosen because information technology is a
changing industry full of constant innovation. It would be beneficial to include data from 2003 to present
to get more data points. Treasury bonds were used as the risk free security to stay consistent with the
risk-free rate and the arithmetic mean used because it more accurately shows an investor’s value in a
company today rather than return over time.
Country risk premium was difficult to estimate for Microsoft. Their 10k releases only show two
geographical locations of the United States and other countries. To make some estimation of what
country risk premium would be I took the five highest GPDv countries and calculated their average
default risk of 0.6% (A2). I took the five highest GPD countries because I believe Microsoft is an
established company that sells products anywhere they can. More developed countries are bound to have
more Microsoft products and therefore it is a guess that these are the five highest countries of sales for
Microsoft.
A comparison of Microsoft’s closing prices to S&P 500’s closing pricesix was used to calculate
the beta (A3). I chose to use this index assuming that the marginal investor had holdings in the largest
companies traded on the NYSE and NASDAQ. I chose the time period of three years to get recent market
data that better reflects company’s current positions than longer time periods. I decided to use a weekly
time interval because this gave me a good amount of data points to reduce statistical noise and also
eliminated some of the volatility from daily trading effects.
I used the above CAPM model because Microsoft should not be completely exposed to the
country risk premium and I do not have the proper data breakdown to calculate a lambda value. Therefore
I used their beta, which assumes they will be as susceptible to country risk as market risk.
Cost of Debt: Pre-Tax = 2.53% + .35 = 2.88% [After-Tax = 2.88% (1-.425) = 1.656%]
The pre-tax cost of debt starts with risk-free rate with a default spread added. According to
Moody’s, Microsoft has an AAA credit rating on outstanding debtvi. The default spread associated with
this rating is 35 basis points, which is added to the risk-free rate. I intentionally left out the country risk
premium component to cost of debt, assuming that Microsoft will issue all debt in the United States. This
is the most mature market they have access to and the only country which generates over 10% of revenue.
The marginal tax rate of 42.5% was used in calculating the after-tax cost of debt. This number is
based solely on the U.S. taxation rates. The federal statutory rate is 35% in the United States and there is
a state portion as well. State income taxes range from 0-12% with an average of 7.5%, according to
KPMG’s tax rate guidevii. Within the rate I did not factor the tax planning or tax benefits that come from
deducting state taxes on your federal return because these are small effects that are hard to estimate.
A1. Data from Daily Treasury Yield Curve Rates iii
9/2/2014
9/3/2014
9/4/2014
9/5/2014
9/8/2014
9/9/2014
9/10/2014
9/11/2014
9/12/2014
9/15/2014
9/16/2014
9/17/2014
9/18/2014
9/19/2014
2.42
2.41
2.45
2.46
2.48
2.50
2.54
2.54
2.62
2.6
2.6
2.62
2.63
2.59
Average
2.53
A2. Data from Deutsche Bank Research: Sovereign Default Probabilities Onlineviii
Country
Default Spread
China
1.1%
France
.7%
Japan
.5%
Germany
.3%
United Kingdom
.4%
Average
.6%
A3. Data from Yahoo Finance!: Microsofti and Yahoo Finance!: S&P 500ix
Response to Feedback:
1.) I chose to continue to use an average of the Treasury bond rates as the risk-free rate. I considered
using a single day’s rate, but the rate has fluctuated up and down within a small range over the
past month. I believe that the rate will continue to oscillate by small amounts and taking the
average over a short period such as this month will give a value that may be more accurate than
any one day of this month.
2.) I considered using an average of all countries’ default spread when calculating the country risk
premium but did not feel this would lead to an accurate number. I believe that Microsoft does
operate in all countries, but somewhat proportionally to their GDP. Assuming this, I did not want
to factor in developing markets that would be associated with large amounts of risk for a very
small portion of their income. This would be a fair method if I had a method to weigh these risks
based on revenue, but the only geographic breakdown provided by Microsoft is all countries
besides the United States. By taking their five highest GDP countries I believe I am capturing
most of the international revenue Microsoft generates because they would have more sales in
these countries.
3.) After reviewing my calculation of beta and how the book explains to arrive at it, I realized I made
a few poor choices. When choosing an index I chose an index of comparable firms, which is
incorrect. I was mixing information from creating a bottom-up beta and a beta from historical
data. The index used should be the holdings of a typical marginal investoriv. Therefore, you can
see how the stock being analyzed fluctuates compared to the index fluctuation. I have corrected
this along with use of a more recent time period, and different time interval explained above.
4.) There were a few suggestions to use a different tax rate based on another country they operate in.
I chose the United States’ rate because I feel that Microsoft would issue debt in the United States
due to it being the most mature and stable market they have access to. By doing this I wouldn’t
factor in another tax rate because the benefits they receive would be based on the interest expense
generated on their United States debt.
5.) I considered providing more breakdowns for international sales and operations, but could not find
any sort of numerical breakdown of revenues or other financial figure. The only distinction
provided by Microsoft was “United States” and “Other Countries.” My only other option would
be to explain where they were targeting expansion, but I felt my space was used better on other
subjects.
6.) I purposely used the data after 1994 in my calculation for market risk premium because I did not
want to include the early start-up period for most technology companies. I feel that this recent
period gives a good figure for the market risk premium in the market conditions today. Data from
before this period may not be represented as well and may just skew the numbers. For my final
valuation this may be an area that I perform a sensitivity analysis on to see if it is an influential
factor.
7.) My choice of using arithmetic mean in the calculation of market risk premium is because
geometric mean gives a value as if the investor held the investment for a long period of time. It
takes into account the compounding effects of the investment, however I was more interested in
what the company’s value is today over a short period of time.
i
Yahoo Finance!: Microsoft, http://finance.yahoo.com/q?s=MSFT.
Microsoft FY14 Annual Report, http://www.microsoft.com/investor/reports/ar13/index.html
iii
Daily Treasury Yield Curve Rates, http://www.treasury.gov/resource-center/data-chart-center/interestrates/Pages/TextView.aspx?data=yield
iv
Chapter 2 from Damodaran, Aswath, 2006, Damodaran on Valuation: Security Analysis for Investment and
Corporate Finance, 2nd edition, Wiley, New York.
v
The World Bank Data: GDP Rankings, http://data.worldbank.org/data-catalog/GDP-ranking-table
ii
Moody’s: Microsoft Corporation,
https://www.moodys.com/page/search.aspx?cy=global&kw=microsoft+corporation&searchfrom=GS&spk=qs&tb=1
vii
KPMG: Corporate Tax Rates Table, http://www.kpmg.com/global/en/services/tax/tax-tools-andresources/pages/corporate-tax-rates-table.aspx
viii
Deutsche Bank Research: Sovereign Default Probabilities Online,
https://www.dbresearch.com/servlet/reweb2.ReWEB?rwnode=DBR_INTERNET_ENPROD$EM&rwobj=CDS.calias&rwsite=DBR_INTERNET_EN-PROD
ix
Yahoo Finance!: S&P 500, http://finance.yahoo.com/q?s=%5EGSPC
vi