Microsoft shares were sharply higher in late trading today after Bloomberg reported that the company is planning to sell debt this year to pay for dividends and share repurchases.  Why would a company with nearly $37 billion in cash on the balance sheet need to issue debt in order to pay dividends or fund repurchases?  The answer is that much of Microsoft’s cash hoard is held overseas and the company would have to pay taxes on earnings that are repatriated to the United States.

A debt offering would also be quite cheap for Microsoft given the company’s strong credit rating and low interest rates.  Bloomberg cited an unnamed source at Microsoft who indicated that the company could raise at least $5 billion without jeopardizing the credit rating.  It is likely that Microsoft will obtain an interest rate below 4 percent, although we do not yet know what kind of debt maturities are under consideration.

Some analysts are predicting an even larger debt offering of up to $10 billion, although this is apparently higher than what company executives are considering.  Microsoft currently pays a 13 cent quarterly dividend and could increase the regular payout significantly or declare a special dividend as it did in 2004.  This would make sense for shareholders if the current 15 percent dividend tax rate is not extended by Congress and reverts to the ordinary income tax rate in 2011.

We recently profiled Microsoft and made many similar points regarding the potential for larger payouts and share repurchases based on the company’s low valuation.

Disclosure:  The author owns shares of Microsoft.