achieved

through the OEM channel during 1997 and 1998.



COST OF REVENUE.  Although cost of revenue as a percentage of revenue decreased

in 1997 and 1998, it varies with channel mix, product mix within channels, and

usage of online operations.  The trend of declining cost of revenue as a

percentage of revenue is unlikely to continue in 1999.



PAY AND PARTICIPATION MODEL.  Microsoft employees currently receive salaries,

incentive bonuses, other fringe benefits, and stock options.  New government

regulations, poor stock price performance, or other factors could diminish the

value of the option program to current and prospective employees and force the

Company into more of a cash compensation model.  Had the Company paid employees

in cash the grant date Black-Scholes value of options vested in 1996, 1997, and

1998, the pretax expense would have been approximately $450 million, $620

million, and $850 million.



LONG-TERM RESEARCH AND DEVELOPMENT INVESTMENT CYCLE.  Developing and localizing

software is expensive and the investment in product development often involves a

long payback cycle.  The Company plans to continue significant investments in

software research and development and related product opportunities from which

significant revenue is not anticipated for a number of years.  Management

expects total spending for research and development in 1999 to increase over

spending in 1998.



SALES, MARKETING, AND SUPPORT INVESTMENTS.  The Company's plans for 1999 include

accelerated investments in its sales, marketing, and support groups.



FOREIGN EXCHANGE.  A large percentage of the Company's sales, costs of

manufacturing, and marketing is transacted in local currencies.  As a result,

the Company's international results of operations are subject to foreign

exchange rate fluctuations.



INVESTMENTS VALUE SENSITIVITY.  The Company's investment portfolio is subject to

interest rate and market price risk.  A 10% increase in treasury security yields

would reduce the carrying value of interest-sensitive securities at June 30,

1998 by $128 million, and a 10% decrease in market values would reduce the

carrying value of the Company's publicly traded equity securities by $300

million.  Many of these equity securities are highly volatile stocks.



INTELLECTUAL PROPERTY RIGHTS.  Microsoft diligently defends its intellectual

property rights, but unlicensed copying of software represents a loss of revenue

to the Company.  While this adversely affects U.S. revenue, revenue loss is even

more significant outside of the United States, particularly in countries where

laws are less protective of intellectual property rights.  Throughout the world,

Microsoft actively educates consumers on the benefits of licensing genuine

products and educates lawmakers on the advantages of a business climate where

intellectual property rights are protected.  However, continued efforts may not

affect revenue positively.



FUTURE GROWTH RATE.  The revenue growth rate in 1999 may not approach the level

attained in prior years.  As discussed previously, operating expenses are

expected to increase in 1999.  Because of the fixed nature of a