Important disclosures appear on the last page of this report.

Krause Fund Research

Spring 2011

Technology Recommendation: Buy

Analysts

Nick Petersen

nicholas-m-petersen@uiowa.edu

Adam Lewis

adam-lewis@uiowa.edu

Brian Shea

brian-shea@uiowa.edu

Company Overview

Microsoft Corporation (MSFT) is a global leader in the

diversified software industry, with 2010 revenue of $62.4

billion. Microsoft divides operations into five business

segments: Windows & Windows Live division, server and

tools, online services division, Microsoft business division,

and entertainment and devices division. The Windows &

Windows Live division and Microsoft business division are

the primary drivers of revenue, accounting for 28.5% and

30.3% of total revenue for 2010.

Stock Performance Highlights 52 week High $31.58

52 week Low $22.73

Beta Value .77

Average Daily Volume (3 Month) 59.06 m

Share Highlights Market Capitalization $213.17 b

Shares Outstanding 8.4 b

Book Value per share $5.77

EPS (last fiscal year) $2.13

P/E Ratio 11.91

Dividend Yield 2.05%

Dividend Payout Ratio 24.4%

Company Performance Highlights ROA 21.79%

ROE 40.63%

Sales $62.4 b

Financial Ratios Current Ratio 2.13

Debt to Equity .86

Microsoft Corporation (NYSE:

MSFT)

April 17, 2011

Current Price $25.37

Target Price $35-37

90’s Golden Stock Still Performs

Microsoft Window’s user-friendly interface and easy

navigation have allowed the software to capture 90% of the

operating systems market. The nearest competitor, Apple,

competes with only 5% market share. Microsoft’s strong and

trusted brand image gives the company a sustainable and long-

term competitive advantage.

Cloud computing is expected to grow at 21.6% per year

until 2014, when revenue is expected to reach $29.5 billion.

With Microsoft’s recent investment in the industry, the company

will use this technology to drive future growth.

Microsoft consistently invests 15% of annual revenue into

R&D. This investment will help Microsoft remain a top

innovator in software.

Microsoft’s expansion into the Smartphone market through

a partnership with Nokia allows Microsoft’s Windows Phone 7

to compete with established competitors like Google’s Android

and RIM’s Blackberry.

One Year Stock Performance

Source: Yahoo!Finance

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Macroeconomic Factors

Macroeconomic factors such as GDP and

unemployment are highly correlated with

demand for computer software. During the

2008-2009 economic crises, individuals and

organizations reduced spending in the software

industry. Recently, the economy has been

improving; real GDP is expected to rise by 2.4%

in 2011. Assuming the economic rebound

continues, we expect growth in the software

industry to return the normal mid-to-high single-

digit range in 2011 (S&P).

Going Lean

Following the credit crisis and resulting

recession, companies are treading cautiously.

Even with an improving economy, companies

hesitate to reinvest in human capital at their pre-

recession levels. The current U.S.

unemployment rate is 9.0%; the Obama

administration projects an 8.6% unemployment

rate for 2012 (Huffington Post). This data

suggests that while the economy is growing,

companies are reluctant to hire more workers.

At the same time, corporate after-tax profits are

increasing, as shown below: g g g g g g g g g g

Rising corporate profits, combined with a steady

and high unemployment rate, means that

companies are “going leaner”. This approach

means that companies are implementing

growth-strategies without hiring workers, which

suggests that companies are becoming more

efficient.

This trend is important to Microsoft because

profits drive corporate technology spending,

which gives Microsoft a strong growth

opportunity (WSJ). We expect the “lean” trend

to continue, driving corporations to invest extra

cash in capital, such as information technology.

On a macroeconomic level, this change could

potentially raise structural unemployment levels

as companies choose to invest in technology

over workers.

Consumer Spending on Technology

From the individual perspective, consumer tech

spending is highly dependent on income and

discretionary spending. The two biggest threats

that we foresee to consumer spending are rising

oil prices and rising inflation; both threats

reduce consumer’s discretionary income. The

demand for oil will be inelastic in the short to

medium term, as our economy continues to

search for a renewable and sustainable

substitute. Likewise, inflation, especially in food

prices, will impact consumer discretionary

income detrimentally. Although inflation hurts

consumer spending, we do not foresee rising

prices as a serious economic issue in the United

States over the next two to three years. We

expect domestic inflation to rise at a 2-3%

annual rate.

U.S Inflation – Percentage Change in CPI

(Forcasts.org)

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Energy Prices

Rising energy costs could potentially slow the

current economic recovery. The U.S. Energy

Information Administration forecasts the

average retail gasoline price to increase to $3.70

per gallon for the current year, and $3.80 per

gallon in 2012. This increased cost will decrease

consumer discretionary spending as well as

increase transportation and production costs. As

fuel supply remains relatively stable, increased

fuel demand in developing countries will drive

oil prices upward. We expect oil prices to reach

prices as high as $140 per barrel in the next two

to three years, compared to current prices of

$108 per barrel.

Crude Oil Prices – Dollars per Barrel

(Forecasts.org)

Government and Tech Spending

Despite budget cuts, the United States is

increasing its total information technology by

3.6% for the current year (FY2011). The

Department of Defense, Department of

Homeland Security, and Department of Health

and Human Services primarily drive this

increase in spending (USAspending.gov). This

is pertinent to Microsoft because the spending

will contribute to future revenue growth.

The Software Industry

The Main Players: Operating Systems

Market Share:

Microsoft – 90%

Apple – 5%

Linux (& others) – 5%

(S&P)

What Drives Software Sales?

Since computer hardware companies depend on

software companies to produce operating

systems and programs to run hardware, software

companies must rely on sales of hardware

manufacturers. For example, a consumer will

likely purchase a new computer equipped with

the most recent Windows operating software

rather than purchasing the software

independently. 75% of Windows sales are

directly to hardware producers.

Innovation drives demand for computer

software. In the early 2000’s, Windows XP was

the dominant operating system software. By

2007, Windows Vista became the new, up-to-

date operating system. Today, Windows 7 is the

latest and most advanced operating system for

computers. We can expect new versions in the

coming years because technology becomes

obsolete quickly.

Two of the main opportunities for future growth

in software are cloud computing and

smartphones. Both technologies will demand

innovative, user-friendly, and efficient operating

systems. If the current operating systems market

is indicative of which systems consumers and

businesses will choose for smart phones and

cloud platforms, we see upside to investors of

Microsoft.

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Future Opportunities – Cloud Computing

Microsoft originally impacted the software

industry with BASIC, followed by MS-DOS,

and now Windows. Microsoft sees its next wave

in cloud computing, which is a technology that

improves the ability to distribute software and

information over the Internet. Users are able to

access tasks and programs from nearly

anywhere with this technology; we expect the

“internet cloud” to drastically improve the

accessibility and distribution of information,

which will increase corporate and individual

efficiency. Estimated revenue from cloud

computing was $11.1 billion in 2009 and is

forecasted to grow at 21.6% annually until

2014, when expected revenue will reach $29.5

billion (IDC).

Cloud computing software is an operating

system that runs on a server from a remote

location. The programs and information on this

operating system connect servers and data

centers to consumers and businesses. The

advantage of using a cloud platform is that a

user does not need to hassle with updates to the

operating system or the storage of files.

Microsoft’s significant investment in research

and development, the company’s market

capitalization, and the company’s experience as

an innovator lead us to see Microsoft as the

market leader in this emerging industry. Since

businesses and consumers have been using

Windows for years, they have a disposition to

choose Windows Azure as a cloud platform.

Microsoft has a three-year partnership with Dell

to deploy and manage virtualization and private

cloud technologies. The deal involves applying

Microsoft’s cloud computing platform, Azure,

to Dell’s hardware. This partnership should

secure Microsoft’s Azure platform as a major

market player in cloud services.

Future Opportunities: Smart Phones

Another significant opportunity for software

companies is the smartphone market. These

phones have evolved into handheld computers

that can perform many of the same tasks as a

personal computer. Like a computer, these

smartphones need easy-to-use operating systems

to appeal to consumers. Worldwide smartphone

use grew by 75 percent in 2010 and is expected

to grow by 49.2% in 2011 (IDC). Apple and

Google currently control most of the

smartphone operating systems, but Windows

recently released software that is expected to

capture significant market share by 2015,

putting the Windows 7 phone second only to

Google’s Android (IDC).

Microsoft

Microsoft is the world’s leader in development

and innovation in the software industry. The

company was founded by Bill Gates in 1975 and

began as a developer of the BASIC computer

program and MS-DOS. The company followed

these programs with Windows, a program that

currently dominates the operating systems

market. In the past ten years, Microsoft has

diversified its operations by producing computer

hardware and consumer electronics such as the

XBOX gaming system and Zune mp3 player,

while continuing the advancement of its

operating systems and desktop software.

Corporate Strategy

Microsoft is in the mature stage of its business

cycle, but has the resources to capture growth

opportunities in the technology sector. While

the company will probably never revisit the

growth rates of the 90’s, Microsoft’s innovative

products and services will create steady long-

term growth for the company. Microsoft

allocates about 15% of its annual revenue to

research and development (MSFT 10K). This

reinvestment leads to newer, better, and more

efficient products and services that individuals

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and organizations continue to purchase. Few

could deny that Windows operating systems and

Microsoft Office software have significantly

increased efficiency. Consumers have learned

that Microsoft develops high-quality and useful

products. We expect this trust to carry forward,

giving the company a sustained competitive

advantage in creating new products. As the

company invests in the “internet cloud,” this

competitive advantage will set the company

apart from competitors in the new industry.

Products and Services

Microsoft reported record revenue of $62.48

billion for its fiscal year ending June 30, 2010,

an increase of 7% from fiscal year 2009.

Microsoft divides its products and services into

five different segments: Windows and Windows

Live, Microsoft Business, Server and Tools,

Online Services, and Entertainment and

Devices. Although Microsoft is primarily a

software developer, the company has recently

begun to create forms of computer hardware and

consumer electronics. This distribution of their

revenue over the past three years is as follows:

Year Ended

June 30,

Revenue (in

millions)

2010 2009 2008

Windows &

Windows Live

$17,788 $14,690 $16,815

Server and

Tools

$14,878 $14,276 $13,217

Online

Services

$2,198 $2,110 $2,164

Microsoft

Business

$18,909 $18,864 $18,904

Entertainment

and Devices

$8,114 $8,035 $8,502

Unallocated /

Other

$597 $462 $818

Consolidated $62,484 $58,437 $60,420

(MSFT 10-K)

The “Windows & Windows Live” division is

typically Microsoft’s largest revenue-generator,

driven by the Windows operating system.

Seventy-five percent of this division’s revenue

stems from operating system software that is

pre-installed by original equipment

manufacturers (OEMs) that produce computers,

such as Dell and Hewlett-Packard. The other

25% of revenues are derived from commercial

retail sales of Windows without included

hardware.

The “Microsoft Business” division develops

productivity-increasing software and services

for businesses and individuals. The primary

products of this division are Microsoft Office,

SharePoint, Exchange, and Lync. These

products generate 90% of the division’s

revenue.

The “Server and Tools” division develops

software and services for information

technology professionals. Products and services

in this division include Windows Server,

Microsoft SQL, Server, Windows Azure,

Windows Embedded device platforms, and

Enterprise Services.

The Online Services division controls

Microsoft’s search engines: Bing and MSN.

These search engines generate revenue by

selling search and display advertising.

The Entertainment and Devices division is

Microsoft’s newest segment. The division

develops hardware, software, and services to

entertain individuals such as the Xbox 360

gaming console, Xbox Games, Xbox live

subscription and accessories, Zunes, and the

Windows Phone.

Research and Development

Microsoft spent $8.7 billion, $9.0 billion, and

$8.2 billion on research and development

expenses during fiscal years 2010, 2009, and

2008, respectively. These expenditures comprise

14%, 15%, and 14% of revenue each year,

respectively (MSFT 10K). Microsoft plans to

continue making these expenditures to create

growth opportunities. Outside the already

discussed opportunities in cloud computing,

Microsoft sees opportunity in natural user

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interfaces, which allow users to control devices

using touch, gestures, handwriting, and speech

recognition.

Major Customers

According to Microsoft’s 2010 10-K, no

individual customer accounted for more than

10% of revenue in any of the past three years.

The most significant type of customer is original

equipment manufacturers (OEMs) that produce

hardware that depends on Microsoft’s software

to operate. This means that the demand for

Windows operating software is derived from the

demand for personal computers.

International Trends

Microsoft has a domestic and international

market. International revenues produce a large

portion of total revenue each year, as seen in the

graph below:

(MSFT 10-K)

We expect that international sales will continue

to steadily increase, driven by sales in emerging

markets.

Partnership with Nokia

The mobile and smartphone markets are

contributing to Microsoft’s international growth.

Between the third quarter of 2009 and the third

quarter of 2010, worldwide mobile phone sales

grew by 35% while smartphone sales grew by

96% (Gartner). Microsoft and Nokia, the current

world market leader in mobile phones with 35%

market share, jointly created a partnership

where Nokia will adopt the Windows Phone as

its primary smartphone. This alliance with

Nokia will drive future sales of the Windows

Phone in a mutually beneficial relationship for

both companies; Nokia’s dominance in the

mobile phone market will be supported by

Microsoft’s dominance in the application

software and operating systems market.

(Microsoft.com).

Competition

Mac vs. PC

Consumers have been led to believe that Apple

will soon dominate the software industry with

the Mac operating system; however, the Mac vs.

PC battle is less a threat to Microsoft than many

consumers would suspect. As of August 2010,

Windows-based PCs encompassed 91% of the

PC market. At the same time, Apple composed

only 5% of this market (S&P NetAdvantage).

Linux also captures about 5% of the market.

(S&P NetAdvantage). We expect that Windows

will remain as the dominant operating system in

the future, based on its user-friendly interface

and widely-used status. Much of Apple’s

revenue growth comes from strong performance

in the hardware and consumer electronics

industries.

Oracle vs. Access

Microsoft maintains a commanding presence in

desktop software. Microsoft Word and Excel

dominate the word processor and spreadsheet

software markets (S&P). Microsoft Access is a

major player in the database market; however,

Oracle poses a threat with its database program.

Although Oracle’s database has more features

and capabilities, Microsoft Access is a cheaper,

easier-to-use program.

Google vs. Microsoft

Google competes with Microsoft’s Bing and

MSN search engines. Google has historically

been the market’s dominant search engine.

0

10,000

20,000

30,000

40,000

2008 2009 2010

Mill

ion

s o

f D

olla

rs

U.S.

International

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However, in the past year, Bing searches have

increased by 6% while Google searches have

decreased by 2% (Hitwise.com). Since

Microsoft’s search engines are not a large

portion of its operations, Microsoft is more a

threat to Google than Google to Microsoft.

Google focuses its operations on the Internet,

while Microsoft focuses on computer software.

Microsoft’s earnings are the highest of its

competitors; this profit leverages extra research

and development investment to maintain a

dominant position in the industry.

A larger battle between Google and Microsoft

concerns smart phones, which was discussed

above.

The following table compares Microsoft to

several of its main competitors:

(Yahoo Finance)

Valuation Analysis

Revenue Forecasting

We project that Microsoft’s biggest increases in

revenue will come from their server and tools

division, which includes their Azure cloud

platform, and the company’s entertainment and

devices division, which includes the Windows 7

phone. This is based on the projected growth for

cloud computing and smart phones through the

continuing value year. We also expect steady

growth in the Microsoft Business division,

fueled by Microsoft office, and growth in the

Windows and Windows Live division as more

companies upgrade to Windows 7.

CV Growth Rate

We chose 3 percent as our continuing value

growth rate to match the average growth in

GDP. The continuing value year represents the

end of a high growth period based on cloud

computing and smart phone markets.

Cost of Revenue

We expect slight increases in costs of revenue as

inflation affects inputs.

Research and Development

Microsoft consistently dedicates approximately

15 percent of their revenue into research and

development. The company believes that the

foundation of their innovation and technological

advancement comes through R&D spending.

Plant Property and Equipment

Microsoft will spend more on PPE in the future

as they open more data centers to store

information in their servers related to their cloud

computing activities.

WACC

CAPM:

Beta: 0.77 based on Bloomberg’s 3-year,

weekly raw beta.

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Risk Free Rate: 4.43% as the YTM on a 30-

year Treasury Bond.

Market Risk Premium: 4.34%

Cost of Equity: 7.77%

After-tax Cost of Debt: 1.92%. Microsoft has

rarely issued debt. We believe that the company

will pay off all the debt within the short-run as

they increase their cash balances with growth.

Invested Capital and Return on Invested

Capital

Microsoft invests majorly in human capital.

Since human capital does not appear on the

balance sheet, ROIC appears unnaturally high.

We believe that as Microsoft invests more in

PPE for data centers, they will reach a more

stable ROIC in the 100-150% range by their

continuing value year.

Share Repurchases

Microsoft often repurchases shares of common

stock with their excess cash. In recent years, the

company issued debt to make large share

repurchases. We expect Microsoft to return to

historic repurchases of around $6 billion

annually.

Dividend Policy

Since 2004, Microsoft has paid a dividend to its

shareholders. In the most recent years, the

dividend has been approximately 27 percent of

its earnings per share. We make the assumption

to hold this constant through the continuing

value year.

Relative P/E Analysis

Microsoft is a very unique company in which

the products and services they provide have

very few companies that have the same

offerings. Due to the nature of this analysis, we

find it hard to achieve a legitimate projection

based on the inputs.

Sensitivity Analysis

We conducted a series of sensitivity analysis

scenarios to provide a reasonable range of stock

prices based on our key assumptions. The first

scenario, shown in the table below, compares

the impact of our beta and continuing value

growth estimates. The reasonable ranges for

these inputs generated a valuation above

Microsoft’s current stock price, reinforcing or

“Buy” rating.

Beta

$42.77 0.70 0.75 0.80 0.85

2.50% 45.34 43.35 41.55 39.90

CV 2.75% 45.42 43.44 41.63 39.97

Growth 3.00% 45.51 43.52 41.70 40.05

3.25% 45.60 43.60 41.78 40.12

3.50% 45.69 43.68 41.86 40.20

The second scenario contrasts the risk free rate

and the market risk premium, generating a

reasonable range of values shown below. Once

again, this sensitivity analysis produced

valuations above the current stock price.

Beta

$42.77 0.70 0.75 0.80 0.85

4.00% 50.11 47.67 45.48 43.49

Risk- 4.25% 47.32 45.16 43.20 41.41

Free 4.50% 44.85 42.91 41.15 39.54

Rate 4.75% 42.64 40.90 39.31 37.85

5.00% 40.65 39.08 37.63 36.30

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Finally, we tested our Beta against our estimated

market risk premium. The beta is perhaps the

most subjective piece of data, while the market

risk premium is based on over 80 years of data.

Even with variation in each, the stock price does

not fall below the current price, which gives

investors a wide margin of safety.

Beta

$42.77 0.70 0.75 0.80 0.85

4.00% 47.94 45.88 44.01 42.29

Market 4.25% 46.13 44.12 42.29 40.61

Risk 4.50% 44.46 42.49 40.71 39.08

Premium 4.75% 42.91 41.00 39.25 37.67

5.00% 41.48 39.61 37.91 36.36

Investment Outlook

Technological innovation is the foundation of

Microsoft’s success. Microsoft plans to continue

investing in research and development to create

new growth opportunities. The most recent

financial crisis has forced many companies to

re-evaluate expenditures and operations, which

we predict will benefit Microsoft as companies

focus on improved efficiency through

technology. We think Microsoft holds a

sustainable competitive advantage in operating

systems by offering the most widely-used and

trusted software in the industry. We think that

attempts to chisel away significant Windows

market share will be futile. An investor cannot

expect that Microsoft will recreate multi-

thousand percent returns as it did in the 1990’s,

but the company has matured into a healthy and

dominant player in software that we see offering

investors market returns, or slightly above

market returns, over the medium to long-term.

This optimistic outlook, combined with our

valuation models, make Microsoft an attractive

investment.

Important Disclaimer

This report was created by students enrolled in

the Security Analysis (6F:112) class at the

University of Iowa. The report was originally

created to offer an internal investment

recommendation for the University of Iowa

Krause Fund and its advisory board. The report

also provides potential employers and other

interested parties an example of the students’

skills, knowledge and abilities. Members of the

Krause Fund are not registered investment

advisors, brokers or officially licensed financial

professionals. The investment advice contained

in this report does not represent an offer or

solicitation to buy or sell any of the securities

mentioned. Unless otherwise noted, facts and

figures included in this report are from publicly

available sources. This report is not a complete

compilation of data, and its accuracy is not

guaranteed. From time to time, the University of

Iowa, its faculty, staff, students, or the Krause

Fund may hold a financial interest in the

companies mentioned in this report.

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Citations http://www.netadvantage.standardandpoors.com

.proxy.lib.uiowa.edu/NASApp/NetAdvantage/sh

owIndustrySurvey.do?code=cos

http://www.huffingtonpost.com/2011/02/14/oba

ma-2012-budget-unemployment-

growth_n_822928.html

http://seekingalpha.com/article/252544-

corporate-profit-margins-likely-to-fall-here-s-

why

http://online.wsj.com/article/SB1000142405274

8703439504576116400253142750.html

http://it.usaspending.gov/?q=content/current-

year-fy2011-continuing-resolution

http://www.idc.com/about/viewpressrelease.jsp?

containerId=prUS22692511&sectionId=null&el

ementId=null&pageType=SYNOPSIS

http://www.gartner.com/it/page.jsp?id=1466313

http://www.microsoft.com/presspass/press/2011

/feb11/02-11partnership.mspx

http://www.hitwise.com/us/press-center/press-

releases/bing-searches-increase-twenty-one-

percent/

Microsoft 10-K (SEC.gov)

http://www.idc.com/getdoc.jsp?containerId=prU

S22762811

http://www.computerworld.com/s/article/92084

78/Android_drives_big_smartphone_growth_in

_2010_IDC_says

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Business Segments: 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVWindows and Windows Live Division 16,815 14,690 17,788 19,567 21,132 22,823 24,649 26,127 26,911 Growth per year -12.6% 21.1% 10.0% 8.0% 8.0% 8.0% 6.0% 3.0% Percentage of Revenue 27.8% 25.1% 28.5% 29.2% 29.3% 29.4% 29.7% 29.9% 29.9%

Server and Tools Division 13,217 14,276 14,878 17,110 19,505 22,041 24,245 25,699 26,470 Growth per year 8.0% 4.2% 15.0% 14.0% 13.0% 10.0% 6.0% 3.0% Percentage of Revenue 21.9% 24.4% 23.8% 25.6% 27.1% 28.4% 29.2% 29.5% 29.5%

Online Services Division 2,164 2,110 2,198 2,308 2,423 2,544 2,646 2,752 2,835 Growth per year -2.5% 4.2% 5.0% 5.0% 5.0% 4.0% 4.0% 3.0% Percentage of Revenue 3.6% 3.6% 3.5% 3.4% 3.4% 3.3% 3.2% 3.2% 3.2%

Microsoft Business Division 18,904 18,864 18,909 19,476 20,061 20,662 21,282 21,921 22,578 Growth per year -0.2% 0.2% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% Percentage of Revenue 31.3% 32.3% 30.3% 29.1% 27.8% 26.6% 25.6% 25.1% 25.1%

Entertainment and Devices Division 8,502 8,035 8,114 8,439 8,945 9,660 10,240 10,752 11,075 Growth per year -5.5% 1.0% 4.0% 6.0% 8.0% 6.0% 5.0% 3.0% Percentage of Revenue 14.1% 13.7% 13.0% 12.6% 12.4% 12.4% 12.3% 12.3% 12.3%

Unallocated and other 818 462 597 - - - - - - Growth per year -44% 29% - - - - - - Percentage of Revenue 1.4% 0.8% 1.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Consolidated Revenues 60,420 58,437 62,484 66,899 72,066 77,731 83,062 87,252 89,869

REVENUE DECOMPOSITION

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Microsoft Inc.Income StatementFiscal Years Ending June 30(numbers in millions)

2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVRevenue 60,420 58,437 62,484 66,899 72,066 77,731 83,062 87,252 89,869Operating expenses:Cost of Revenue 11,598 12,155 12,395 13,380 15,134 17,101 19,104 20,068 20,670Research and Development 8,164 9,010 8,714 10,035 10,810 11,660 12,459 13,088 13,480Sales and marketing 13,039 12,879 13,214 14,718 15,855 17,101 18,274 19,195 19,771General and administrative 5,127 3,700 4,004 5,017 5,405 5,830 6,230 6,544 6,740Employee severence 0 330 59 0 0 0 0 0 0Total operating expenses 37,928 38,074 38,386 43,150 47,203 51,691 56,067 58,895 60,662

Operating Income 22,492 20,363 24,098 23,749 24,863 26,040 26,995 28,357 29,208Interest Expense 0 0 (151) 0 0 0 0 0 0Dividend/Interest Income 888 706 843 1,254 1,351 1,457 1,557 1,636 1,685Gain/Loss on Investment 434 (683) 208 418 450 486 519 545 562Gain/Loss on Foreign Currency 0 (509) 1 0 0 0 0 0 0Other Income (Expense) 0 (56) 14 0 0 0 0 0 0Total Other Income (Expense) 1,322 (542) 915 1,672 1,802 1,943 2,077 2,181 2,247

Income Before Taxes 23,814 19,821 25,013 25,422 26,664 27,983 29,072 30,538 31,454Provision for income taxes 6,133 5,252 6,253 10,035 10,810 11,660 12,459 13,088 13,480

Net Income 17,681 14,569 18,760 15,387 15,855 16,323 16,612 17,450 17,974

Earnings per share:Basic 1.9 1.63 2.13 1.77 1.84 1.91 1.96 2.07 2.14

Weighted avg. shares outstanding:Basic 9,328 8,945 8,813 8,705 8,613 8,538 8,477 8,430 8,395

Cash div. declared per common sh. 0.44 0.52 0.52 0.48 0.50 0.52 0.53 0.56 0.58

12

Microsoft Inc.Balance SheetFiscal Years Ending June 30(numbers in millions)

2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVAssetsCurrent assets:Cash and cash equivalents 10,339 6,076 5,505 9,090 26,296 43,734 61,236 79,314 97,778Short-term investments 13,323 25,371 31,283 32,221 33,188 34,184 35,209 36,266 37,354Total cash, cash equivalents, and ST investments 23,662 31,447 36,788 41,312 59,484 77,918 96,445 115,579 135,131Accounts receivable, net 13,589 11,192 13,014 13,380 14,413 15,546 16,612 17,450 17,974Inventories 985 717 740 1,338 1,441 1,555 1,661 1,745 1,797Deferred income taxes 2,017 2,213 2,184 1,820 1,456 1,092 728 364 0Other current assets 2,989 3,711 2,950 3,345 3,603 3,887 4,153 4,363 4,493Total current assets 43,242 49,280 55,676 61,195 80,398 99,998 119,600 139,501 159,396Property and equipment, net of accumulated depreciation 6,242 7,535 7,630 8,028 8,648 9,328 9,967 10,470 10,784Equity and other investments 6,588 4,933 7,754 7,987 8,226 8,473 8,727 8,989 9,259Goodwill 12,108 12,503 12,394 12,394 12,394 12,394 12,394 12,394 12,394Intangible assets, net 1,973 1,759 1,158 1,338 1,441 1,555 1,661 1,745 1,797Deferred income taxes 949 279 0 0 0 0 0 0 0Other long-term assets 1,691 1,599 1,501 2,007 2,162 2,332 2,492 2,618 2,696Total assets 72,793 77,888 86,113 92,948 113,270 134,079 154,842 175,717 196,326

Liabilities and stockholders' equityCurrent liabilities:Accounts payable 4,034 3,324 4,025 4,014 4,324 4,664 4,984 5,235 5,392Short-term debt 0 2,000 1,000 0 0 0 0 0 0Accrued compensation 2,934 3,156 3,283 3,261 3,513 3,789 4,049 4,254 4,381Income taxe payable 3,248 725 1,074 2,509 2,702 2,915 3,115 3,272 3,370Short-term unearned revenue 13,397 13,003 13,652 13,380 14,413 15,546 16,612 17,450 17,974Securities lending payable 2,614 1,684 182 0 0 0 0 0 0Other current liabilities 3,659 3,142 2,931 3,718 4,531 5,363 6,194 7,029 7,853Total current liabilities 29,886 27,034 26,147 26,882 29,484 32,277 34,954 37,240 38,970Long-term debt 0 3,746 4,939 4,116 3,293 2,470 1,646 823 0Long-term unearned revenue 1,900 1,281 1,178 1,338 1,297 1,244 1,246 1,309 1,348Deferred income taxes 0 0 229 0 0 0 0 0 0Other long-term liabilities 4,721 6,269 7,445 7,436 9,062 10,726 12,387 14,057 15,706Total liabilities 36,507 38,330 39,938 39,771 43,135 46,717 50,233 53,429 56,024

Stockholder's equity:Common stock and PIC - 24,000 shares authorized 62,849 62,382 62,856 60,017 57,424 55,095 53,052 51,317 49,912Retained Earnings (Deficit) -26,563 -22,824 -16,681 -6,840 12,711 32,267 51,556 70,972 90,390Total stockholder's equity 36,286 39,558 46,175 53,177 70,135 87,362 104,608 122,288 140,302

Total liabilities and stockholder's equity 72,793 77,888 86,113 92,948 113,270 134,079 154,842 175,717 196,326

13

Microsoft Inc.Cash Flow StatementFiscal Years Ending June 30(numbers in millions)

2008 2009 2010OperationsNet income 17,681 14,569 18,760Adjustments to reconcile net income to net cash from operations:Depreciation, amortization, and other noncash items 2,056 2,562 2,673Stock-based compensation 1,479 1,708 1,891Net recognized losses (gains) on investments and derivatives (572) 683 (208)Excess tax benefits from stock-based compensation (120) (52) (45)Deferred income taxes 935 762 (220)Deferral of unearned revenue 24,532 24,409 29,374Recognition of unearned revenue (21,944) (25,426) (28,813)Changes in operating assets and liabilities:Accounts receivable (1,569) 2,215 (2,238)Other current assets 153 (422) 420Other long-term assets (98) (273) (223)Other current liabilities (748) (3,371) 1,295Other long-term liabilities (173) 1,673 1,407Net cash from operations 21,612 19,037 24,073

FinancingShort-term borrowings (repayments), maturities of 90 days or less, net 0 1,178 (991)Proceeds from issuance of debt, maturities longer than 90 days 0 4,796 4,167Repayments of debt, maturities longer than 90 days 0 (228) (2,986)Common stock issued 3,494 579 2,311Common stock repurchased (12,533) (9,353) (11,269)Common stock cash dividends paid (4,015) (4,468) (4,578)Excess tax benefits from stock-based compensation 120 52 45Other 0 (19) 10Net cash used in financing (12,934) (7,463) (13,291)

InvestingAdditions to property and equipment (3,182) (3,119) (1,977)Acquisitions of companies, net of cash acquired (8,053) (868) (245)Purchases of investments (20,954) (36,850) (30,168)Maturities of investments 2,597 6,191 7,453Sales of investments 25,132 19,806 15,125Securities lending payable (127) (930) (1,502)Net cash used in investing (4,587) (15,770) (11,314)Effect of exchange rates on cash and cash equivalents 137 (67) (39)

Net change in cash and cash equivalents 4,228 (4,263) (571)

Cash and cash equivalents, beg. of period 6,111 10,339 6,076Cash and cash equivalents, end of period 10,339 6,076 5,505

14

Microsoft Inc.Cash Flow StatementFiscal Years Ending June 30(numbers in millions)

2011E 2012E 2013E 2014E 2015E 2016CVCash Flows from Operating ActivitiesNet Income 15,387 15,855 16,323 16,612 17,450 17,974 Increase in accounts receivable (366) (1,033) (1,133) (1,066) (838) (524) Increase in inventories (598) (103) (113) (107) (84) (52) Increase in accounts payable (11) 310 340 320 251 157 Increased in accrued compensation (22) 252 276 260 204 128 Increase in short-term unearned revenue (272) 1,033 1,133 1,066 838 524 Increase in long-term unearned revenue 160 (41) (53) 2 63 39 Increase in income taxes payable 1,435 194 212 200 157 98

Net cash provided by operating activities 15,713 16,466 16,985 17,288 18,042 18,344

Cash Flows from Investing Activities Increase in short-term investments 0 0 0 0 0 0 Increase in long-term investments (233) (240) (247) (254) (262) (270) Increase in PPE (398) (620) (680) (640) (503) (314) Increase in Intangibles (180) (103) (113) (107) (84) (52)

Net Cash used for Investing Activities (811) (963) (1,040) (1,001) (848) (636)

Cash Flows from Financing Activities Increase (decrease) in LT debt (823) (823) (823) (823) (823) (823) Increase (decrease) in ST debt (1,000) 0 0 0 0 0 Payment of Dividends (4,154) (4,281) (4,407) (4,485) (4,712) (4,853) Common Stock Repurchases (6,000) (6,000) (6,000) (6,000) (6,000) (6,000)

Net Cash provided by Financing Activities (11,978) 896 770 691 465 324

Net Increase (Decrease) in Cash 2,925 16,399 16,715 16,979 17,659 18,031

Cash, Beginning of Year 5,505 8,430 24,829 41,544 58,522 76,181

Cash, End of Year 8,430 24,829 41,544 58,522 76,181 94,213

15

Microsoft Inc.Common Size Income StatementFiscal Years Ending June 30(percentage of sales)

2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVRevenue 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Operating expenses:Cost of Revenue 19.20% 20.80% 19.84% 20.00% 21.00% 22.00% 23.00% 23.00% 23.00%Research and Development 13.51% 15.42% 13.95% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%Sales and marketing 21.58% 22.04% 21.15% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00%General and administrative 8.49% 6.33% 6.41% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%Employee severence 0.00% 0.56% 0.09% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Total operating expenses 62.77% 65.15% 61.43% 64.50% 65.50% 66.50% 67.50% 67.50% 67.50%

Operating Income 37.23% 34.85% 38.57% 35.50% 34.50% 33.50% 32.50% 32.50% 32.50%Other Income (Expense) 2.19% -0.93% 1.46% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50%

Income Before Taxes 39.41% 33.92% 40.03% 38.00% 37.00% 36.00% 35.00% 35.00% 35.00%Provision for income taxes 10.15% 8.99% 10.01% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Net Income 29.26% 24.93% 30.02% 23.00% 22.00% 21.00% 20.00% 20.00% 20.00%

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Microsoft Inc.Common Size Balance SheetFiscal Years Ending June 30(percentage of total assets)

2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVAssetsCurrent assets:Cash and cash equivalents 17.11% 10.40% 8.81% 14.55% 42.08% 69.99% 98.00% 126.93% 156.48%Short-term investments 22.05% 43.42% 50.07% 51.57% 53.11% 54.71% 56.35% 58.04% 59.78%Total cash, cash equivalents, and short-term investments 39.16% 53.81% 58.88% 66.12% 95.20% 124.70% 154.35% 184.97% 216.27%Accounts receivable, net 22.49% 19.15% 20.83% 21.41% 23.07% 24.88% 26.59% 27.93% 28.77%Inventories 1.63% 1.23% 1.18% 2.14% 2.31% 2.49% 2.66% 2.79% 2.88%Deferred income taxes 3.34% 3.79% 3.50% 2.91% 2.33% 1.75% 1.17% 0.58% 0.00%Other 4.95% 6.35% 4.72% 5.35% 5.77% 6.22% 6.65% 6.98% 7.19%Total current assets 71.57% 84.33% 89.10% 97.94% 128.67% 160.04% 191.41% 223.26% 255.10%Property and equipment, net of accumulated depreciation 10.33% 12.89% 12.21% 12.85% 13.84% 14.93% 15.95% 16.76% 17.26%Equity and other investments 10.90% 8.44% 12.41% 12.78% 13.17% 13.56% 13.97% 14.39% 14.82%Goodwill 20.04% 21.40% 19.84% 19.84% 19.84% 19.84% 19.84% 19.84% 19.84%Intangible assets, net 3.27% 3.01% 1.85% 2.14% 2.31% 2.49% 2.66% 2.79% 2.88%Deferred income taxes 1.57% 0.48% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Other long-term assets 2.80% 2.74% 2.40% 3.21% 3.46% 3.73% 3.99% 4.19% 4.31%

Total assets 120.48% 133.29% 137.82% 138.94% 157.18% 172.49% 186.42% 201.39% 218.46%

Liabilities and stockholders' equityCurrent liabilities:Accounts payable 6.68% 5.69% 6.44% 6.42% 6.92% 7.46% 7.98% 8.38% 8.63%Short-term debt 0.00% 3.42% 1.60% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Accrued compensation 4.86% 5.40% 5.25% 5.22% 5.62% 6.06% 6.48% 6.81% 7.01%Income taxes 5.38% 1.24% 1.72% 4.01% 4.33% 4.67% 4.98% 5.24% 5.39%Short-term unearned revenue 22.17% 22.25% 21.85% 21.41% 23.07% 24.88% 26.59% 27.93% 28.77%Securities lending payable 4.33% 2.88% 0.29% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Other 6.06% 5.38% 4.69% 5.95% 7.25% 8.58% 9.91% 11.25% 12.57%Total current liabilities 49.46% 46.26% 41.85% 43.02% 47.19% 51.66% 55.94% 59.60% 62.37%Long-term debt 0.00% 6.41% 7.90% 6.59% 5.27% 3.95% 2.63% 1.32% 0.00%Long-term unearned revenue 3.14% 2.19% 1.89% 2.14% 2.08% 1.99% 1.99% 2.09% 2.16%Deferred income taxes 0.00% 0.00% 0.37% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Other long-term liabilities 7.81% 10.73% 11.92% 11.90% 14.50% 17.17% 19.82% 22.50% 25.14%Total liabilities 60.42% 65.59% 63.92% 63.65% 69.03% 74.77% 80.39% 85.51% 89.66%

Stockholder's equity:Common stock and PIC - 24,000 shares authorized 104.02% 106.75% 100.60% 89.71% 79.68% 70.88% 63.87% 58.81% 55.54%Retained deficit -43.96% -39.06% -26.70% -10.22% 17.64% 41.51% 62.07% 81.34% 100.58%Total stockholder's equity 60.06% 67.69% 73.90% 79.49% 97.32% 112.39% 125.94% 140.16% 156.12%

Total liabilities and stockholder's equity 120.48% 133.29% 137.82% 138.94% 157.18% 172.49% 186.42% 201.39% 218.46%

17

Microsoft Inc.Value Driver EstimationFiscal Years Ending June 30(numbers in millions)

2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVNOPLATEBITA: Revenue 60,420 58,437 62,484 66,899 72,066 77,731 83,062 87,252 89,869 Total operating expenses 37,928 38,074 38,386 43,150 47,203 51,691 56,067 58,895 60,662EBITA 22,492 20,363 24,098 23,749 24,863 26,040 26,995 28,357 29,208 Less Adjusted Taxes:Income Tax Provision 6,133 5,252 6,253 10,035 10,810 11,660 12,459 13,088 13,480Tax Shield on Interest Expense 0 0 53 0 0 0 0 0 0Tax on Interest and Investment Income 463 (190) 320 585 631 680 727 763 786Adjusted Taxes 5,670 5,442 5,986 9,450 10,179 10,979 11,732 12,324 12,694Net Deferred Tax (2,966) (2,492) (1,955) (1,820) (1,456) (1,092) (728) (364) 0Change in Deferred Tax 322 474 537 135 364 364 364 364 364NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877

Invested CapitalOperating Current Assets: Normal Cash (10% of sales) 6,042 5,844 6,248 6,690 7,207 7,773 8,306 8,725 8,987 Accounts Recievable 13,589 11,192 13,014 13,380 14,413 15,546 16,612 17,450 17,974 Inventory 985 717 740 1,338 1,441 1,555 1,661 1,745 1,797 Other Current Operating Assets 2,989 3,711 2,950 3,345 3,603 3,887 4,153 4,363 4,493Total operating current assets 23,605 21,464 22,952 24,753 26,664 28,760 30,733 32,283 33,252 Minus operating current liabilities: Accounts Payable 4,034 3,324 4,025 4,014 4,324 4,664 4,984 5,235 5,392 Income Tax Payable 3,248 725 1,074 2,509 2,702 2,915 3,115 3,272 3,370 Accrued Compensation 2,934 3,156 3,283 3,261 3,513 3,789 4,049 4,254 4,381 ST Unearned Revenue 13,397 13,003 13,652 13,380 14,413 15,546 16,612 17,450 17,974 Other current Liabilities 3,659 3,142 2,931 3,718 4,531 5,363 6,194 7,029 7,853 Total operating current liabilities 27,272 23,350 24,965 26,882 29,484 32,277 34,954 37,240 38,970

Net Working Capital (3,667) (1,886) (2,013) (2,129) (2,819) (3,517) (4,221) (4,956) (5,719) Plus Net PPE 6,242 7,535 7,630 8,028 8,648 9,328 9,967 10,470 10,784 Plus PV of operating leases 1,807 1,954 1,579 1,768 1,981 2,218 2,485 2,783 3,117 Plus Net intangible assets 1,973 1,759 1,158 1,338 1,441 1,555 1,661 1,745 1,797 Plus Other LT Assets 1,691 1,599 1,501 2,007 2,162 2,332 2,492 2,618 2,696 Minus long term unearned revenue 1,900 1,281 1,178 1,338 1,297 1,244 1,246 1,309 1,348 Minus Warrenty liabilities 278 132 69 - - - - - - Minus other liabilities 4,721 6,269 7,445 - - - - - - Invested Capital 1,147 3,279 1,163 9,674 10,115 10,672 11,138 11,350 11,328

ROIC NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877 Divided by beginning invested capital (1,306) 1,147 3,279 1,163 9,674 10,115 10,672 11,138 11,350 ROIC -1313% 1342% 569% 1241% 156% 152% 146% 147% 149%

FCF NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877 Minus change in Invested Capital 2,453 2,132 (2,115) 8,511 441 556 466 212 (23) FCF 14,691 13,264 20,765 5,924 14,606 14,868 15,160 16,184 16,900

EP NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877 ROIC -1313% 1342% 569% 1241% 156% 152% 146% 147% 149% WACC 7.39% 7.39% 7.39% 7.39% 7.39% 7.39% 7.39% 7.39% 7.39%EP 17,240 15,311 18,407 14,349 14,333 14,677 14,838 15,574 16,039

Non Operating AssetsCash on Hand 10,339 6,076 5,505 9,090 26,296 43,734 61,236 79,314 97,778"Normal Cash" 6,042 5,844 6,248 6,690 7,207 7,773 8,306 8,725 8,987Excess Cash 4,297 232 (743) 2,400 19,090 35,961 52,930 70,589 88,791 Short-term Investments 13,323 25,371 31,283 32,221 33,188 34,184 35,209 36,266 37,354Long-term Investments 6,588 4,933 7,754 7,987 8,226 8,473 8,727 8,989 9,259Non Operating Assets 24,208 30,536 38,294 42,609 60,504 78,618 96,866 115,843 135,403

18

Microsoft Inc.Weighted Average Cost of Capital (WACC) Estimation

Beta 0.77 Bloomberg (3 year weekly)CAPM:Rf Rate 4.43%Risk Premium 4.34%Cost of Equity 7.77%After-tax Cost of Debt 1.92% Using Marginal Tax Rate = 35%

Current Price 25.37Shares 8,400,000,000

Market Value of Equity 213,108Market Value of Debt/Leases 14,963Market Value of Firm 228,071

WACC 7.39%

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Microsoft Inc.Discounted Cash Flow (DCF) and Economic Profit (EP) Model ValuationFiscal Years Ending June 30

Assumptions: CV growth 3.00%CV ROIC 149%WACC 7.38%Cost of Equity 7.77%

2011E 2012E 2013E 2014E 2015E 2016CV

DCF ModelFCF 5,924 14,606 14,868 15,160 16,184 377,249 PV(FCF) 5,517 12,667 12,007 11,401 11,335 264,204 PV(FCF) 317,130$ +PV(Non-Oper) 38,294$ - PV(Debt) (14,963)$ - PV(ESOP) (689)$ - PV(Operating Leases) (1,579)$ PV(Equity) 338,193$ Shares Outstanding (millions) 8,400 Target Price 40.26$ Adjusted Target Price 42.82$

EP ModelROIC 1241% 156% 152% 146% 147% 149%EP 14,349 14,333 14,677 14,839 15,574 365,899 PV(EP) 13,362 12,430 11,853 11,159 10,907 256,255 PV(EP) 315,967$ Invested Capital 1,163$ PV(Operations) 317,130$ + PV(Non-Oper) 38,294$ - PV(Debt) (14,963)$ - PV(ESOP) (689)$ - PV(Operating Leases) (1,579)$ PV(Equity) 338,193$ Shares Outstanding (millions) 8,400 Target Price 40.26$ Adjusted Target Price 42.82$

Discount Factors 1.07 1.15 1.24 1.33 1.43 1.43

Today 4/25/2011Next FYE 6/30/2011Last FYE 6/30/2010Days in FY 365 Days to FYE 299 Elapsed Fraction 0.819

20

Relative P/E AnalysisEPS EPS

Ticker Company Price 2011E 2012E P/E 11 P/E 12AAPL Apple Inc. 348.51$ $22.97 $26.46 15.2 13.2 CSCO Cisco Systems, Inc. 17.15$ $1.59 $1.76 10.8 9.7 GOOG Google Inc. 530.70$ $34.55 $39.92 15.4 13.3 AMZN Amazon.com Inc. 180.01$ $3.19 $4.43 56.4 40.6 ORCL Oracle Corp. 34.18$ $2.17 $2.39 15.8 14.3

Average 22.7 18.2

MSFT Microsoft Co. 25.37$ $1.77 $1.84 14.4 13.8

Implied Value: Relative P/E * EPS 2011 $ 40.13 Relative P/E * EPS 2012 33.55$

21

Microsoft Inc.Dividend Discount Model (DDM) or Fundamental P/E Valuation ModelFiscal Years Ending June 30

2011E 2012E 2013E 2014E 2015E 2016CV

EPS 1.77$ 1.84$ 1.91$ 1.96$ 2.07$ 2.14$

Key Assumptions CV growth of EPS 3.00% CV ROE 11.72% Cost of Equity 7.77%

Future Cash Flows P/E Multiple 14.35 EPS(next period) 2.14$ Future Stock Price 33.38 Dividends Per Share 0.48 0.50 0.52 0.53 0.56 Future Cash Flows 0.48 0.50 0.52 0.53 33.94

Discounted Cash Flows 0.442853 0.428$ 0.412$ 0.392$ 25.160$

Intrinsic Value 26.39$ Adjusted Price (Today) 28.07$

22

Ratio Analysis2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E

Liquidity Ratios:Current Ratio 1.45 1.82 2.13 2.28 2.73 3.10 3.42 3.75 4.09

Cash Ratio 0.79 1.16 1.41 1.54 2.02 2.41 2.76 3.10 3.47

Asset Turnover Ratios:Asset Turnover 0.83 0.75 0.73 0.72 0.64 0.58 0.54 0.50 0.46

Financial Leverage Ratios:Debt Ratio 0.06 0.15 0.16 0.12 0.11 0.10 0.09 0.08 0.08

Debt-to-Equity Ratio 0.13 0.30 0.29 0.22 0.18 0.15 0.13 0.12 0.11

Profitability Ratio:Return on Equity 49% 37% 41% 29% 23% 19% 16% 14% 13%

Return on Assets 24% 19% 22% 17% 14% 12% 11% 10% 9%

Dividend Policy Ratios:Payout Ratio 23% 32% 24% 27% 27% 27% 27% 27% 27%

Dividend Yield 1.88% 1.82% 1.75% 1.67% 1.63% 1.57%

23