Your help is greatly needed for this two part question, which I am
having a difficult time in answering. The question is:
"What are the costs and benefits of having surplus long-term financing
when it is not needed?  How should the firm manage this surplus?"

Dear Dana3:

There are many advantages and disadvantages to having a surplus of
long-term financing.  According to Brealey & Myers (page 727), there
is no convincing theoretical analysis of the best level of long-term
financing relative to a firm's capital requirement.  However, there
are certainly costs and benefits associated with maintaining a
surplus.

A firm with a surplus never has to worry about borrowing to pay the
following month's bills.  The firm also has plenty of money to invest
in new projects to grow its business.  In volatile industries, such as
the automotive industry, a surplus when times are good can be
essential to sustaining the firm during downturns.  A surplus may also
be desirable if the firm has the opportunity to lock in long-term
financing at attractive interest rates in anticipation of rising
interest rates. However, these benefits do not come without costs.

A firm with plenty of money to invest in new projects runs the risk of
losing focus and not investing sensibly, thereby earning poor returns
on invested capital.  The surplus may also be wasted in other ways,
such as building an extravagant new corporate headquarters.  In the
absence of attractive projects within the firm to invest in, the firm
may elect to purchase Treasury bills, other marketable securities,
and/or to act as a venture capitalist by investing in other companies.
 After taxes, the results from the firm's investing activities may be
poorer than what the firm's investors could have achieved had the
capital been returned to them to invest themselves.

Generally, it is sensible to finance the firm's permanent working
capital requirements and long-lived assets like plants and machinery
with long-term debt and equity.  Beyond this, the firm must consider
its growth prospects, the stability of its industry, the economic
climate, and the opportunity cost its investors' will incur if the
firm invests the surplus in itself or marketable securities instead of
returning it to its investors.  If the surplus is short-lived or not
large, no action needs to be taken.  If, however, a firm has a
permanent sizable cash surplus, it should consider retiring long-term
securities by paying off debt and/or buying back stock and/or paying a
dividend to reduce its long-term financing to a level at or below its
cumulative capital requirement.  A mix of short-term and long-term
financing is generally more optimal.

An example of a firm currently facing this issue is Microsoft.  The
company has an enormous cash hoard, but until recently paid no
dividend at all, and has only now begun paying a modest one.  Bill
Gates has always been extremely financially conservative, desiring to
maintain at least a year of operating expenses on hand in cash even as
the company has grown to a considerable size.  However, now that the
company's growth prospects appear to be decreasing, investors are
increasingly clamoring for a sizable dividend to reduce Microsoft's
apparent long-term financing surplus.

Sincerely,

Wonko

The page referenced above is found in "Principles of Corporate
Finance" Fourth Edition, by Brealey & Myers, McGraw-Hill Inc., 1991

Thank you so very much, the answer was prefect. Also thank you for the
resource reference.