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For example, why did Microsoft take on debt to create shareholder value?

http://www.bloomberg.com/news/2010-09-13/microsoft-is-said-to-plan-debt-sale-to-pay-for-dividends-buy-back-shares.html

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    I think this should be made more general, using Microsoft's debt sale as an example. I.e "Why would a company sell debt in order to buy back shares and/or pay dividends?" – George Marian Sep 29 '10 at 3:12
  • Good suggestion. – Sheehan Alam Sep 29 '10 at 3:13
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I believe that article provides some good reasons, though it may be a bit light on technical details and there are likely other reasons a company would do it.

  1. Apparently much of its cash is held overseas, which would pare down the cash pile if brought back into the U.S.
  2. With their high credit rating (and probably due to current market conditions) a bond sale would be relatively cheap
  3. As long as they do not take on too much debt, it does not matter that debt is used to finance a buyback and/or dividend payments. The shares are bought back -- bringing down the number of shares on the market, thus boosting share price -- and/or shareholders are payed their dividends.

So, if they can finance for less then they would lose to taxes by bringing the money home and they do not take on too much debt, this will likely work just fine and increase share holder value.

Hopefully, someone else can provide some other reasonable scenarios.

The bottom line is that it does not matter how they finance the share buybacks and/or dividend payments as long as they do not shoot themselves in the foot while doing it.

  • For Microsoft, debt right now is cheaper than dirt. – user296 Sep 30 '10 at 18:16
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It's a tax shelter. Foreign affiliates hold most of Microsoft's cash and investments. The cost of borrowing is much cheaper than repatriating the money and paying taxes. Those bonds are selling at rates similar to US Treasury Debt.

Also, many people and organizations with lots of assets still borrow money for day to day expenses. Why? You tend to make a better return on investments which are committed for a number of years, and the timing of income from those investments may not coincide with your expenses.

2

There is a substantial likelihood over the next several years that the US Dollar will experience inflation. (You may have heard terms like "Quantitative Easing.") With inflation, the value of each dollar you have will go down. This also means that the value of each dollar you owe will go down as well.

So, taking out a loan / issuing a bond at a very good rate, converting it into an asset that's a better way to store value (possibly including stock in a big stable company like MSFT) and then watching inflation reduce the (real) value of the loan faster than the interest piles up... that's like getting free money.

Combine that with the tax-shelter games alluded to by everyone else, and it starts to look like a very profitable endeavour.

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When I play Railroad Tycoon III, I often send my company deep into debt to get cash on hand to buy back shares, effectively increasing my ownership of the company as an absolute percentage. Then I issue massive dividends until my company goes bankrupt, and start a new company.

It's a way to shuttle money borrowed against a company's assets into my personal bank account at no risk to me.

In the MSFT case, maybe they think there will be inflation and this is a hedge against holding so many dollars in cash already. If they can borrow a couple billion in 2010 dollars and pay it back in 2015 dollars, they're probably going to end up ahead if all they do is buy back shares.

Paying dividends with the money seems stupid vs. buying back shares - they're just driving up income taxes for investors.

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My answer is not specific, or even maybe applicable, to Microsoft.

Companies don't want to cut dividends. So they have a fixed expense, but the cashflow that funds it might be quite lumpy, or cyclical, depending on the industry.

Another, more general, issue is that taking on debt to retire shares is a capital allocation decision. A company needs capital to operate. This is why they went public in the first place, to raise capital.

Debt is a cheaper form of capital than equity. Equity holders are last in line in a bankruptcy. Bondholders are at the front of the line. To compensate for this, equity holders require a larger return -- often called a hurdle rate.

So why doesn't a company just use cheaper equity, and no debt? Some do. But consider that equity holders participate in the earnings, where bondholders just get the interest, nothing more.

And because lenders don't participate in the potential upside, they introduce conditions (debt covenants) to help control their downside exposure.

For a company, it's a balance, very much the same as personal finances. A reasonable amount of debt provides low-cost capital, which can be used to produce greater returns. But too much debt, and the covenants are breached, the debt is called due immediately, there's no cash to cover, and wham! bankruptcy.

A useful measure, if a bit difficult to calculate, is a company's cost of capital, and the return on that capital. Cost of capital is a blended number taking both equity and debt into account. Good companies earn a return that is greater than their cost of capital. Seems obvious, but many companies don't succeed at this. In cases where this is persistent, the best move for shareholders would be for the company to dissolve and return all the capital.

Unfortunately, as in the Railroad Tycoon example above, managers' incentives aren't always well aligned with shareholders, and they allocate capital in ways advantageous to themselves, and not the company.

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Businesses have bond ratings just like people have credit ratings. It has become common for businesses to issue low rate bonds to show that they are strong, and leave the door open for further borrowing if they see an opportunity, such as an acquisition.

One of the reasons Microsoft might want to build a credit reputation, is that people become familiar with their bonds and will purchase at lower rates when they want to borrow larger amounts of money, rather than assuming they are having financial issues which would lead them to demand higher rates.

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