This Is Exactly How Much Debt Will Help Apple

Alongside Apple's (NASDAQ: AAPL  ) earnings release last week, the company dropped a capital structure bombshell: It will be tapping the debt markets to raise cash. This has been a topic of debate for some time, since Apple's cash balance has reached legendary status.

Some investors may initially think the move counterproductive: Why raise debt when you have cash?

All abroad
The first reason is that the bulk of Apple's cash -- $102.3 billion to be precise -- is currently held overseas by foreign subsidiaries. Apple would face quite a tax bill if it wanted to repatriate those dollars back home.

Source: SEC filings. Calendar quarters shown. MRQ = most recent quarter.

At the same time, investors have been demanding that Apple return more cash, so the only way to balance those two interests is to tap debt markets to raise domestic cash.

In theory
The other benefit to Apple of raising debt is to reduce the company's weighted average cost of capital, or WACC. How much of a benefit are investors possibly looking at? Let's start with the WACC formula.

Figuring out Apple's current WACC is fairly straightforward, because it currently has no debt. Using the capital asset pricing model, I estimate Apple's current cost of equity at 8.5%, lower than my February estimate of 10.5%. This is because Apple's volatility (measured by beta) has declined and the risk-free rate (measured by 10-year Treasury yields) has also declined. The equity risk premium is largely unchanged.

With no debt, Apple's current WACC is simply its cost of equity, or 8.5%. Let's now add in some debt.

Lever up, WACC down
The (1-t) component above represents the tax break that comes with debt, since interest expense is tax-deductible. Like all American corporations, Apple faces a statutory federal income tax rate of 35%, which is what applies here. Apple's effective tax rate is much lower (around 26%), in part because of keeping foreign earnings "indefinitely reinvested" abroad.

As far as estimating the cost of debt, let's say that Apple issues paper with a 2.25% coupon. That would be slightly higher than 10-year Treasuries (Apple carries the same credit rating as the U.S. government) as well as the 1.25% that IBM borrowed at earlier this year.

Using these estimates, this is how differing amounts of debt raised would affect Apple's WACC right now.

Debt Raised

Annual Interest Expense

WACC

$0 (current)

$0 (current)

8.5%

$20 billion

$450 million

8.15%

$40 billion

$900 million

7.83%

$60 billion

$1.35 billion

7.54%

$80 billion

$1.8 billion

7.28%

$100 billion

$2.25 billion

7.03%

Source: Author's calculations.

If Apple raised up to $100 billion in debt, it could realize a WACC reduction as high as 1.5%. Realistically, though, the company will sell between $40 billion and $60 billion in paper, because it still generates operating cash flow domestically. Apple's generated $6.2 billion in cash domestically over the past year, which is after paying out $9.4 billion in dividends and buybacks so far.

It may be an implicit gain shrouded in financial theory, but Apple investors can look forward to seeing Apple's overall cost of capital come down.

With Apple's cost of capital about to decline, is now the time to buy Apple? The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.


Read/Post Comments (4) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2013, at 1:25 AM, lakawak wrote:

    Where are all the fanboys that argued that the amount of Apple's cash that was in foregin countries was only $30 billion or so?

  • Report this Comment On April 29, 2013, at 3:23 PM, milfalcon wrote:

    Can they use the foreign cash to pay off the interest from the debt they are issuing without taking a tax hit? If so I guess this makes sense. If not, I still don't get it.

  • Report this Comment On May 09, 2013, at 5:01 PM, RobertC314 wrote:

    So.... what is the gain? How much taking out $50bn in debt increase the enterprise value of Apple?

  • Report this Comment On May 09, 2013, at 9:07 PM, RobertC314 wrote:

    How much *does* taking out $50bn in debt increase the enterprise value... I might get better answers if my questions make sense.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2391882, ~/Articles/ArticleHandler.aspx, 9/30/2014 10:19:58 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement